Factored In
In the world of investing, factors are nothing new and are often used as a tool for diversification. With factor-based approaches, however, many investors often focus on just two dominating categories: growth and value. There is continuous debate as to which category is better over the long-term. However, there is one factor that has worked well but gets less attention than we feel it deserves – quality.
Gateway has found that quality is a characteristic of durable companies with resilient business models that reflect historical profitability and strong fundamentals with the potential to outgrow the average company over time. Specifically, quality companies tend to demonstrate stable earnings, high return on equity and assets, regularly generate high levels of cash flow, and tend to have low leverage. These stocks often offer broad market participation while maintaining the potential for defense.
Standing Out
Quality is a concept as old as time and often applicable throughout life. With investing, however, a quality focus can help investors weather many environments – providing the potential to benefit from rising markets while also offering protection during market stress.
Quality over the long-term, as reflected by the S&P 500® Quality Index, has shown the ability to provide a standout risk and return profile relative to the broad market and other factors. The S&P 500® Quality Index (the Index) is designed to track high quality stocks in the S&P 500® Index, selected based on quality score. The Index’s quality score for individual stocks is calculated using return on equity, accruals ratio, and financial leverage ratio. While the past cannot predict the future, results over the past 15 years show this quality factor-based index has provided robust performance and superior risk-adjusted returns relative to the broad S&P 500® Index as well as other popular factor based investment approaches.
Making A Difference
Global markets have experienced significant changes creating persistent uncertainty on a number of fronts. In such an environment, it is increasingly important to take a holistic view of business health. Focusing on durable businesses with fortress-like balance sheets that can withstand full economic cycles, rather than focusing exclusively on valuation or yield, can add a meaningful layer of protection through times of uncertainty or market stress. For example, consider the period after the Tech Bubble in early 2000 to 2002 or during the Great Financial Crisis from 2007 to 2009. During these periods, as shown below, high-quality companies often performed better and provided a source of defense relative to the broad S&P 500® Index and ranked well among other factors.
Keeping Score
Gateway’s investment team spent significant time researching a multitude of factors and found that by emphasizing quality within an equity portfolio, investors have the potential to harness the benefits of healthy firms and balance long-term growth with defense. With an expertise in quantitatively driven equity portfolio management, the investment team identified key metrics that indicate strong, quality companies. The team developed a distinct and disciplined equity investment process aiming to increase a portfolio’s overall Quality Score which is driven by a focus on key fundamental variables.
The process results in a highly-diversified portfolio emphasizing companies with established track records of profitability and strong fundamentals while eliminating companies that are highly levered with poor balance sheets. With discretion, the team enhances the Quality Score of an equity portfolio by identifying opportunities to maximize profitability metrics and minimize leverage metrics. For Gateway’s Quality Income strategy, this results in an equity portfolio emphasizing the highest quality names from the S&P 500® Index and relative overweightings to historically high-quality sectors.
Go for Quality
In an uncertain world that is constantly changing, the durability offered by the quality factor is increasingly important for investors. The resilience of high-quality companies has shown the potential to outgrow average companies over time, offering broad market participation or potential outperformance and may provide defense during market turmoil. As the factor debate continues between the cyclicality and performance of value, growth, and other factors, investors may want to consider the strong, time-tested alternative – quality.
Past Performance does not guarantee future results
Data sources: Morningstar DirectSM
For more information and access to additional insights from Gateway Investment Advisers, LLC, please visit www.gia.com/insights.
