What constitutes a true quality growth stock?

That stems from a painful 2022 for many quality growth companies, which suffered last year from the strong rotation to value. To some investors, certain quality stocks now look more like value stocks. 

The meaning of quality has, to be clear, not changed – as the meaning of sustainability does not change. What did change in 2022 is the pricing of quality growth. This was triggered by the pandemic-induced supply chain complications that boosted inflation and interest rate levels in a dramatic form in the first half of 2022.

The volatile capital markets forced many equity investors to the sidelines or to high-yielding stocks that, on a yield basis, compare better with high interest rate levels. This caused the sharp growth to value rotation last year. 

Investors have to thoroughly consider the merits of each business individually.

The extent of the rotation has been quite extreme, due to elevated fears for potentially structurally high inflation and interest rate levels. The level of reprising of many quality stocks therefore has also been to quite extreme levels, and many of them dropping to valuation levels earlier perceived to be the domain of value shares. 

The question, therefore, is not whether the definition of quality has changed in 2022, but rather whether 2022 has changed the characteristics and strategic long-term outlook of the particular business.

Investors have to thoroughly consider the merits of each business individually in this context, and may well come to the conclusion in some cases that their quality business has simply become very attractively valued.

Is there a difference now between a value manager and a quality manager?

This is a key question in the context of recent volatility.

Quality managers have a clearly defined universe of candidates they consider for their portfolio. Those businesses are structurally the long-term outperformers. Many of them have become very attractively valued in 2022 because of the inflation scare and its effect on capital markets. Potential investors consider the particular mandate for its sustainable long-term outperformance potential.

Value managers consider the level of cheapness of a business, with less focus on its investment merits and its sustainability. Their orientation is more tactical, clearly with more of a trading consideration.

We believe stock-trading values do not get the scrutiny it deserves.

They seek to utilise the short-term mis-pricing of an asset and at times may over-estimate the market’s willingness to ‘correct’ the pricing of a deteriorating asset. By implication, their universe of candidates is predominantly determined by pricing and an investor has little consideration of any strategic direction.

Today, value managers may well consider some quality candidates and include them in their portfolios. As capital market circumstances normalise and risk appetite improves, however, they may soon sell them again and remain with low quality, low valuation multiple stocks.

On the reverse, those quality managers who in 2022 tried to hide from the style rotation in value stocks may possibly have breached their mandate.

The value style of investing is dependent on solid economic growth and real interest rate levels to outperform on a sustainable basis. Current circumstances do not seem very favourable in this context.

Should investors pay more attention to portfolio turnover?

We believe stock-trading values do not get the scrutiny it deserves. Open-ended fund investors may believe their fund trades daily and that they can sell all of their holding any day. While true, the more hidden issue is the liquidity of underlying holdings and the risk this poses to remaining investors. Potentially their exposure to illiquid positions in the portfolio may grow as other investors are exiting the fund.

Current investment flows from the very liquid US market to the much less liquid Europe and emerging markets highlight the risks. For example, French equities are currently at a record overweight level (+2 per cent) against its MSCI AC index weight. Apart from its positive effect on valuation levels, the risk is on the reverse one day when these global investors may start selling in large volumes.

There is a vast number of characteristics that in full define a quality stock, we condense it all to three words: quality is sustainability.

Comfort can be drawn by looking at the number of portfolio holdings that have been held since inception.

In our case, nine (almost a third) of the portfolio holdings have been held from initially constructing the portfolio almost 10 years ago. This highlights the value of a strategic orientation of holding high-quality growth sustainable businesses. It also saves significantly on trading costs. 

While there is a vast number of characteristics that in full define a quality stock, we condense it all to three words: quality is sustainability. It is about the ability of the business to continue delivering organic growth in excess of normal economic growth. 

Gerrit Smit is portfolio manager of the Stonehage Fleming Global Best Ideas Equity Fund