THE PERENNIAL DEBATE IN FACTOR INVESTING: IT IS QUALITY VERSUS VALUE
Serious investment buffs would broadly define investing into three large buckets viz active, passive, and factor investing.
Active fund management has a strong ‘natural intelligence’ orientation and is largely dependent on the perspicacity of the fund manager. Passive investments remain focused on tracking benchmark compositions to generate benchmark– linked returns.
While active and passive investment strategies lie at opposite ends of the spectrum, factor investing acts as the optimal combination of the two. Consensus indicates that these factors include size, momentum, low volatility, quality, value, and growth, among others. These factors are added layers and generally deliver superior risk adjusted returns.
Each factor stands out on its own merit. Having said that, two of the most researched factors have been ‘quality’ and ‘value’.
Quality, as defined by quality indices, consistently prioritize high return on equity, stable earnings growth, and low financial leverage while evaluating a company’s investment potential. On the other hand, value as defined by value indices, emphasize low price to earning, low price to book and high dividend yield.
If one were to slice and dice the data available through the reasonably long history of these indices, and juxtapose them with their parent broad-based indices, some very interesting points come through.
Calendar year returns: Analysing calendar year returns over the last 19 years, both the Nifty 200 Quality 30 index (Q30) and the Nifty Midcap 150 Quality index outperformed their parent indices viz Nifty 200 and Nifty 100 around 58% of times. Interestingly, however, the Nifty 50 value index outperformed its parent index 67% of the time in the last 15 years. It alludes to the conclusion that the more broad-based the index, the more incidence of quality outperforming value and vice versa. In any case, calendar year returns are a relatively shorter-term lens to view these factors.
Rolling five-year returns: The difference is quite stark if one compares the relative outperformance of these indices over a rolling five-year period.
Nifty 200 Quality 30 and Nifty 100 Quality 30 outperformed their parent indices 82% and 38% of the times, respectively. The difference is even more stark with the Nifty Midcap 150 Quality 50, which outperformed its respective parent index 89% of the times. In the case of Nifty 500 Value 50 & Nifty 50 Value 20, they outperformed their respective benchmarks 46% and 81% of the times, respectively.
This not just alludes to the smoothness of returns over a longer period, but also the stark incidence of quality being a vastly superior tool in the mid- and small-cap segment.
Drawdowns and volatility: Double clicking on the above data numbers, one finds that astute stock selection plays a very important role in delivering performance, due to the incidence of very sharp drawdowns, especially in the case of value stocks. Drawdowns are far sharper when it comes to value. Historically, most quality companies trade at premium multiples. However, the valuations of quality companies with sustainable moat have narrowed down too much. Over the next two years, will likely regain their valuations as the earnings growth largely remain restricted to a limited universe of high-growth stocks trading at reasonable price.
Quality emphasizes durable business models, sustainable competitive advantages, and strong financials, making it attractive for investors seeking long-term returns and during times of volatility. With India’s growth potential, focusing on quality can be advantageous, offering both return potential and downside protection in the evolving landscape.
Valuation of quality companies with sustainable moats have narrowed