Beware of managers claiming a ‘changed’ approach

The old saying goes that equity markets ‘climb a wall of worry’.

Well, currently there is a great deal of worry but a distinct lack of climbing going on globally. At the time of writing, year-to-date returns in European markets are well into the red, albeit elsewhere some indices remain up on the year. We are well above financial crisis market lows, but at the same time any relief rally is short lived – based on the recent Spanish bailout agreement, only a couple of hours in duration. Is this a signal that we are reaching the point of capitulation? If the darkest hour truly is before dawn then, perhaps, we should be looking for upside in equities?

I am not sure anyone can reliably predict turning points in markets, and that is certainly not my intention here. What is weighing on my mind, though, is that there are two near-consensus trades currently – underweight risk assets, and a bias to ‘quality’ within equities. Fitch Ratings recently commented that the average manager was focused more on finding growth than value, and that stock selection processes were changing in line with the view that quality growth was more important than an attractive valuation. Investors are, apparently, worried about being caught in ‘value traps’ and so would rather pay a higher price for something with more certainty.

In itself buying quality stocks with high returns on equity, strong cash flow and sustainable growth is not a bad long-term investment strategy. In fact, in the (very) long term, it can deliver both strong returns and low absolute volatility, and so in some ways is the ‘ideal’ investment approach. But Fitch’s report raises two concerns – first, is ‘quality’ becoming a crowded trade? Second, are we seeing fund managers changing their approaches to ‘jump on the bandwagon’?

I think the jury is out on the first of these points. The issue is complicated by the fact that there is no one definition of ‘quality’ (in fact, almost every fund manager I have met in the past decade has given a different explanation). This is a good thing: not everyone is chasing the same stocks, even if they are giving them the same label. Conversely, we cannot easily measure the performance of ‘quality’ in all its forms to see whether or not it is overvalued. The same might not be the case for subsets of quality. As I have said before in this column, simplistic equity income strategies – that lack detailed fundamental analysis as part of their stock-selection process but simply chase yield – might offer the perception of quality but in reality are probably both a crowded trade and are not buying, on average, stocks with genuinely higher-quality characteristics. It is therefore too simplistic to say that an equity income strategy will give a bias to quality, although there are managers out there for who this is the case.