The Great Rotation: Why quality stocks are poised to lead again
19 OCT, 2016
The era of the index and easy stock market gains is over – the time for stock picking and investing in quality is now. Markets are priced for perfection, leaving little room for disappointment – the MSCI World index, for example, trades at valuations not seen since 2000. Concentration risk adds to the market fragility. The top 10 stocks in the MSCI World account for almost 30 per cent of the index, up from 10 per cent a decade ago.
Subsequently, market leadership has narrowed considerably, with a relatively small group of companies and investment themes driving a disproportionate share of market gains. Some of the largest gains reflect the AI trade, while others stem from favourable external factors, such as higher interest rates or rising oil and gas prices. By contrast, other sectors have been weak, with many of the world’s greatest businesses seemingly out of favour, down significantly from their highs.
But many high-quality businesses haven’t sold off because their competitive positions have weakened – it’s mainly because short-term sentiment has weighed on their valuations. Many trade at levels that reflect temporary headwinds rather than a change in their structural earnings power. This has widened the gap between price and intrinsic value, making a compelling case for owning the highest-quality businesses.
As long-term investors, we focus on business fundamentals and believe quality will matter even more in the years ahead. Investing in quality means selecting companies operating in the real economy, producing real things or providing real services for real people. This is the way of the world. It is what quality is about, what we invest in and what makes us optimistic for the future.
Quality companies generate high, stable returns on capital and compound them over time. These businesses have well-known brands, genuine competitive moats, strong balance sheets and experienced management teams that allocate capital effectively, prioritising higher-return opportunities over empire-building.
For us, quality is not a marketing label – it is the non-negotiable core of our investment philosophy. Our rigorous process ensures that every company we invest in meets strict criteria. They have enduring competitive advantages, robust balance sheets, real pricing power and management teams devoted to long-term value creation.
Over the past decade, it has been a rising-tide-lifts-all-boats scenario – investors could buy almost anything and it would go up. But those days are gone. The era of low interest rates and low inflation is behind us. Markets are fully priced, while many stocks are overvalued.
After a decade of effortless gains from index investing, the environment is changing markedly. Today’s market concentration and macroeconomic landscape make stock selection – and a focus on quality – more important than ever. With valuations stretched, the case for owning the world’s highest-quality businesses is compelling.
Quality is on sale. The challenges are real – and so is the opportunity. When the rotation comes, it will be fast and significant. We believe that moment is now.
