Good stocks aren’t good enough anymore.
According to Goldman Sachs, investment strategies that use a “quality” tilt have become less successful in recent years and struggle to do better than the overall market. While the investment bank does see “pockets” of companies that can generate outperformance, the view is the latest example of how many such investing “factors” seem ill-suited to the current environment.
Quality investing favors companies with such characteristics as strong corporate governance, balance sheets, and earnings quality. While these are still considered positive attributes, Wall Street over the past several years has favored names that fit into the “growth” category.
The iShares Edge MSCI USA Quality Factor ETF QUAL, -0.41% a quality-themed exchange-traded fund that is a popular way for investors to use this strategy, is up nearly 19% over the past 12 months. That return is lower than the 24% gain posted by the iShares S&P 500 Growth IVW, -0.77% as well as the 22% gain of the S&P 500 SPX, -0.44% overall.
“The alpha available from a simple buy-and-hold quality strategy has fallen markedly,” Goldman wrote in a note to clients, noting the lower dispersion between good stocks and bad stocks within a sector. “The companies delivering 40% sector-relative outperformance over three years are now just as likely to have started year zero in the bottom quintile for returns on capital as they are to have come from the top quintile.” The term “alpha” refers to outperformance relative to a comparable benchmark.
Goldman added that “the penalty for misdiagnosing quality has only intensified” for investors of late. “We have seen average sector-relative underperformance of 33% for stocks that fell from the top quintile to one of the bottom three over the last five, 3-year investing periods.”
Because of the difficulty of picking stocks, investors have increasingly gravitated toward passive investing, where one buys a fund that simply holds the same components as an underlying index, and in the same ratios. Data have repeatedly shown that this strategy essentially always does better over time than active investing, where securities are selected individually.
The change in quality investing means that for active equity investors, “it may be necessary to become more active, accepting more tracking error, longer holding periods, and fewer positions,” Goldman wrote.
Despite this outlook, the Goldman analysts—led by Hugo Scott-Gall, the head of the firm’s thematic research team—do see stocks that qualify as quality names, and which it believes can beat the market in the future.
“While maintaining our bedrock focus on competitive advantage, access to long-term growth, and ESG [environmental, social, and corporate governance] performance, we prioritize growth and positive momentum in returns on capital—companies which won’t just maintain high returns but also expand them,” the analysts wrote. “However, we also look for two types of defensive characteristics, lengthening periods of industry leadership, and/or high and rising free cash flow. Last but not least, we pay more attention to valuation to confront the headwind from higher multiples.”
The investment bank listed 50 names that fit this criteria, a collection that spans sectors and regions, though more than half the names are based in the U.S.
The list includes several names that have surged thus far in 2017, including Apple Inc. AAPL, -1.02% Amazon.com Inc. AMZN, -1.32% Facebook Inc. FB, -1.41% and Alphabet Inc. GOOGL, -2.07% the parent company of Google. Other notable names include Visa Inc. V, -0.05% Colgate-Palmolive Co. CL, -0.46% Estee Lauder Companies Inc. EL, +0.40% and Nike Inc. NKE, -0.78%
“The key ingredients of competitive advantage haven’t changed and likely never will—entry barriers should always be critical as should pricing power and access to growth,” the firm wrote.