There is strengthening support for an equity investment strategy tilted towards quality stocks (i.e. the growth style) in a slowing macroeconomic environment. The following are key factors to consider:
Many economists expect the current low growth environment to persist since it will take some years for consumers and governments to reduce, in some cases extreme, levels of indebtedness. Given that there is further downside risk to global growth, the equity market premium for quality stocks should expand. The current premium relative to value stocks or fixed income is not excessive in our view. Quality stocks are typically those with high returns on equity, low gearing and structural (rather than cyclical) growth stories. Companies growing sustainably are most likely to outperform when earnings growth rates generally are falling or low. During periods of constrained credit, companies with sustainable earnings tend to attract capital (i.e. their cost of capital falls), while companies with low-quality earnings become less attractive to sources of capital (i.e. their cost of capital rises). Companies in well-structured industries are less capital constrained and should be better placed to reward shareholders with dividends or capital returns since they need to retain less capital to sustain the business and their credit ratings. Quality stocks tend to outperform cyclical stocks when the yield curve is flat or inverted, i.e. when growth is expected to be weak or in periods of economic uncertainty. With global interest rates at multi-decade lows, there is a further argument in favour of quality growth stocks.
In summary, Arnhem Investment Management1 believes the equity market at present provides an attractive entry point for investments in quality stocks in attractive industries.
This is an extract from a research paper by Arnhem Investment Management for professional investors. A PDF of the paper is available HERE.