6 June 2022
Ziņas un Viedokļi
Would you like some non-quality in your Portfolio?

Short-term gains, long-term pains

As economic cycles shift, certain areas of the market are rewarded and others are shun, making it difficult for active managers to beat the benchmark if their philosophy is naturally skewed towards sectors falling out of favour. The times like we witness now, provide a good stimulus for one to challenge their beliefs.

To do just that, we have examined the strategies that are delivering alpha in the current environment to answer a simple question: what the reasons for success are and how sustainable the situation is? Let us look at some of the best-performing funds this year.

Table.1: selection of best-performing YTD

Performance as of 31/03/2022

Selection criteria: fund must: 1)  be classified as Equity Global by Lipper; 2) be domiciled in EU, Switzerland or US/Canada; 3) invest in broad-based equity (e.g., funds focusing on specific themes, sectors, as well as funds with investment into bonds and alternative assets are excluded; 4) have at least 5-year history of performance; fund’s official benchmark is used, otherwise benchmark provided by Reuters is used;

Source: Alphinox, Reuters

We notice a clear pattern: behind a dazzling YTD performance there lies a bleak picture as we look at historical picture. Digging into composition of the sample funds (see Chart 1), it comes as no surprise. Peers are allocated broadly in line with the benchmark – a little bit of everything. Our top 8 strategy, on the other hand, is overweighted in IT, Health Care and Communication Services and notably underweighted in Energy and Financials. While our strategies, too, have a higher share of Materials, we focus on businesses that provide high-value-added solutions, such as Sika and Givaudan, while peers also do not shun commodity-type business models. Indeed, in turbulent times, such “have-it-all” approach, has proven to be beneficial, but over a longer period, returns quickly evaporate. Contrasting that, even though our high-conviction strategies have experienced drawdowns this year, over longer horizons, returns look more appealing, and this is the reason why we do not change our investment strategy according to prevailing market conditions.

Chart.1: sectoral allocation of sample funds vs. quality strategies

Source: Alphinox, Reuters

Separating quality from junk

Even though cyclical businesses do occasionally pop up on our radar, as they reach peak profitability, our approach relies on consistent quality, which they simply cannot provide, and so they do not make the cut to the portfolios. Looking at the basket of top-performing holdings YTD, we see a mix of volatile enterprises – companies one might want to consider for the short-term, if one can find the right entry and exit point – most often a futile endeavor. Chart 2 shows development of fundamental characteristics of the 100 top-performing assets YTD in the MSCI World, compared to quality. Quality has delivered steady margins expansion, growing capital returns and consistent earnings growth, while the recent market darlings are not only a step lower fundamentally, but have also shown no improvement – so it is no surprise they have been trailing the market over the past decade.

Chart.2: development of financials of top-performing companies YTD vs. quality universe

Source: Alphinox, Reuters

High quality growth

While one might argue that Energy, Materials and Financials are attractive from valuation perspective (see Chart 3), there is a reason for such multiples. Low-quality businesses benefit from cyclical tailwinds and degree of certainty about their growth is low. Meanwhile, quality companies have consistent earnings, supported by secular trends. E-commerce penetration ratio in US is only 13%, up from 4% in 2010, driving expansion of Amazon. Semiconductor content in electronics has grown to a record high of 33% in 2021, up from 26% in 2010 – a clear reason why stocks, such as Texas Instruments and Nvidia have been long-term compounders. These and other trends are still relevant, and will help quality to deliver earnings growth-driven returns, as multiples have contracted.

Chart.3: Growth estimates and valuation multiples in different sectors

Source: Alphinox, Reuters

In it for the long run

Although it is important to diversify, companies of subpar quality are not the place to be in for long-term oriented investors, which is why we stick to the strongest businesses out there. Ability to identify the leaders and stay away from the laggards is what differentiates active management from passive ETFs and drives long-term alpha.


Author: Alphinox team, alphinox.com

About Alphinox

Alphinox is part of an independent asset manager group with expertise in capital management operating in accordance with Quality investment style. By combining investment expertise and long-term experience in analysing global financial markets, Alphinox develops customized investment solutions and provides analytical research.