Thematic Investment Spotlight: Providing Clarity on Quality

Constructing portfolios in an environment of tight monetary policy, contracting earnings, and uncertain economic conditions is a daunting task. To help give us conviction in our strategy, we utilize a three-pillar framework to identify factors (the underlying components of a security or portfolio’s return) that present investment opportunity over a 9- to 12-month investment horizon. This framework incorporates macroeconomic conditions, valuations, and momentum of different factors and has a strong track record over the last 20 years. Today there is one factor that consistently ranks higher than the rest: quality. We have and continue to look for ways to increase our quality exposure across asset classes and portfolios.

What is quality?

The quality factor can be defined in different ways, and the one we utilize most often combines high profitability (return on equity), low earnings variability, and low leverage (debt to equity).¹ Our equity team seeks out quality companies across sectors, but there are certainly some sectors that garner a higher representation in quality factor indices, including technology, communication services, and consumer staples. This may seem counterintuitive, as tech-related companies have exhibited a higher sensitivity to market swings over the last year and have appeared riskier than the broader market. But when push comes to shove, these companies still exhibit attractive profitability characteristics with sound balance sheets. The interest-rate environment, though, has wreaked havoc on the valuations of some of the more speculative names in the technology sector, admittedly dragging down some higher quality names in the process.

Why quality now?

Today’s investment environment is favorable for the quality factor. The combination of tight monetary policy and higher-for-longer interest rates gives an advantage to less-indebted companies. Profitability and earnings stability are also more appreciated by investors in a challenging earnings backdrop (Figure 1). Earnings for the S&P 500 are currently projected to contract between the fourth quarter of 2022 and second quarter of 2023. Consensus estimates earnings to recover in the second half of 2023, but that timeline could get pushed out if the U.S. economy is in recession. More profitable companies with pricing power are likely to protect their margins better than the broader market in such a challenging backdrop. The S&P 500 overall is expected to see its net profit margin further decline to 11.4% in the fourth quarter of 2022 from a peak of 13.0% in the second quarter of 2021 ².

Figure 1: A weak earnings environment supports the quality factor

Average annualized excess return for the quality factor

Data includes monthly returns for the Barra quality factor from June 30, 1995 through December 30, 2022. Earnings expansions (contractions) are defined as a positive (negative) 3-month % change in S&P 500 EPS. The excess returns shown are the excess return generated by the quality factor over the MSCI USA index when controlling for other factors. Sources: Bloomberg, MSCI, WTIA.

Past performance cannot guarantee future results. Indices are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses such as management fees and transaction costs which will reduce returns.

You may be wondering why anyone would ever want to hold a portfolio other than one focused on high quality. In fact, lower quality names benefited tremendously from the low inflation, low interest-rate environment of the post-Global Financial Crisis era. A surprise pivot from the Fed toward aggressive rate cuts poses a risk to the quality factor.

Seeking out higher quality names is particularly important for the small-cap asset class. The Russell 2000 Index of small cap companies today has nearly double the percentage of non-earners as the index’s long-term average, making the small cap asset class vulnerable to a period of sustained, high interest rates. Combining a quality screen with active management is our preferred approach to small cap equities.

Seeking out quality

Our quality bias is evident across client portfolios. In Portfolio Architect and our “outsourced CIO” portfolios, we utilize a mix of active and passive proprietary and external strategies to implement an overweight to quality across asset classes. As mentioned above, our tilt toward quality is most pronounced in the U.S. small-cap equity asset class, which worked well in 2022.

Our quantitatively oriented portfolios use a direct-indexing-like approach to isolate factors in U.S. large cap, and those portfolios also favor quality. The flexibility of this strategy also allows the profitability factor to be more heavily emphasized.

Screening for quality has long been a part of the process for our proprietary equity strategies, including the Enhanced Dividend Income, Dividend Growth, and Disciplined Core equity strategies. All three of these portfolios have a higher exposure to quality than their benchmarks, which contributed to solid outperformance in 2022.

Core narrative

Today’s environment of tight monetary policy, higher-for-longer interest rates, and weak earnings strongly favors the quality factor, and it consistently ranks near the top in our factor work. The biggest risk to a quality bias is a pivot from the Federal Reserve that ushers in a new era of easy money. We see that as unlikely but are prepared to adjust portfolios accordingly. Across portfolios we hold a slightly defensive posture, with a modest underweight to equities and overweight to cash and investment-grade fixed income.

¹This methodology is consistent with MSCI’s factor methodology and similar to Barra’s.

²Source: Factset, as of January 20, 2023.

³ Source: Strategas Research Partners. Reflects the average since 1990.

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The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.

Past performance cannot guarantee future results. Investing involves risk and you may incur a profit or a loss.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market.

Russell 2000 Index measures the performance of approximately 2,000 smallest-cap American companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. stocks.

S&P 500 index measures the performance of approximately 500 widely held common stocks listed on U.S. exchanges.  Most of the stocks in the index are large-capitalization U.S. issues.  The index accounts for roughly 75% of the total market capitalization of all U.S. equities.