Buying quality stocks in challenging times is a winning long-term strategy

Q2FY25 was a reset quarter for the market. FIIs were selling due to higher valuations and concerns about earnings growth, which was in single digits and not broad-based as it was in calendar year 2023. Investors are now being selective, so companies that deliver high growth will start outperforming value or momentum stocks. The next three years will likely be positive for a focused, bottom-up, growth-oriented style of investment. 

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Below is a brief note about the quality vs value debate. It includes a data point that shows clearly how quality has dominated value over the long term.

Quality vs value

Quality-focused growth-oriented fund houses – which focus not just on growth but quality and duration of growth, the total addressable market, and the moat and self-sufficiency of the business – have outperformed value and momentum stocks, especially over long periods of time.

If one were to slice the data from the reasonably long history of benchmark indices and juxtapose them with their parent broad-based indices, some very interesting points emerge.

• Calendar-year returns: An analysis of calendar-year returns over the past 20 years shows both the Nifty 200 Quality 30 index (Q30) and the Nifty Midcap 150 Quality index outperformed their parent indices – Nifty 200 and Nifty 100 – around 60% and 55% of the time, respectively. Interestingly, however, the Nifty 50 value index outperformed its parent index 69% of the time over the past 16 years. This leads to the conclusion that the more broad-based the index, the higher the incidence of quality outperforming value, and vice versa.
• Rolling five-year returns: The difference is quite stark if one compares the relative outperformance of these indices over a rolling five-year period. The Nifty 200 Quality 30 and Nifty 100 Quality 30 outperformed their parent indices 79% & 38% of the time, respectively. The difference is even more stark with the Nifty Midcap 150 Quality 50, which outperformed its parent index 85% of the time.

This doesn’t just show the smoothness of returns over a longer period but also that quality is a vastly superior tool in the mid- and small-cap segments.

Volatility and drawdowns

A deeper analysis of these figures indicates that astute stock selection plays a crucial role in delivering performance, owing to the incidence of extremely sharp drawdowns, especially in the case of value stocks. Drawdowns are far sharper when it comes to value. The last five-year cycle, preceding and following covid, gives us an interesting data set to mull over. While this is not definitive as a trend, it lends credence to the theory that quality beats value over long periods.

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If you were to take a few stocks out of the quality index and analyse them over 2018-20 (pre-covid) and 2020-22 (during and after covid), you’d see quality stocks have clearly been able to deliver better compound annual returns over the 2018-23 owing to to smaller drawdowns during periods of stress.

Having said that, the Nifty PSU Bank Index (Value) continues to do better than its private-sector counterpart (quality) over this period. Historically, most quality companies have traded at premium multiples. However, the valuations of quality companies with sustainable moats have narrowed tremendously. Over the next two years, these companies will likely regain their valuations as the earnings growth largely remains restricted to a small universe of high-growth stocks trading at reasonable prices.

Where should you invest?

Overall, quality indicates durable business models, sustainable competitive advantages, and strong financials, making this factor attractive for investors seeking long-term returns and during times of volatility. 

Also, in the past six months we have seen events turn in favour of quality over value stocks. Many investment themes such as railways, defence and PSU banks have taken a beating, while a number of quality cyclicals such as non-banking financial companies, consumer discretionary companies and auto firms have outperformed.

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In this evolving scenario, investing in quality-focused fund houses offers investors access to forward-thinking strategies that target high-growth opportunities in sectors that are shaping India’s future.

Vikaas M Sachdeva is managing director of Sundaram Alternate Assets.