Quality and growth investing: Where to from here?

By Jayson Forrest

With continued market uncertainty and a challenging environment ahead for equities, Rick Schmidt (Harding Loevner) explains why quality stocks underperformed in 2022, and why they are likely to perform better in the current environment

Investing in rapidly growing businesses has been a great investment strategy for much of the last decade, and astute investors enhanced their risk-adjusted returns by applying quality filters that provided balance during periods of market instability. But these risk/return factors failed spectacularly during 2022 and many of the investment darlings ended the year well in the red. In contrast, many value investors enjoyed a period of success.

In explaining why, Rick Schmidt CFA – Partner, Portfolio Manager, and Analyst at Harding Loevner – points to the investing philosophy of this United States-based manager and the types of stocks it carries in its portfolio. They are quality-growth companies that have lower risk, more growth and are generally more profitable than other stocks in the market.

Speaking at the 2023 IMAP Portfolio Management Conference in Sydney, Rick says this approach to portfolio management has been a great long-term strategy for Harding Loevner, but concedes this strategy hasn’t been as successful over the challenging economic and market conditions of the last 12-18 months.

Historically, in previous rising interest rate environments, the Harding Loevner portfolio had been protected from any underperformance of growth stocks by the quality stocks of its portfolio. It defines quality as a business with: free cashflow, stronger balance sheets, and less volatility over time. However, this did not happen in 2022. The quality stocks did not protect the portfolio in the bear market. But why?

“There have been many things holding back growth, everything for geopolitical concerns, inflation, energy prices, right through to global growth post the COVID pandemic. As a result, growth stocks have significantly underperformed in the last year, which didn’t really come as a surprise considering the type of market cycle we were in,” he says. “But what was a surprise was the underperformance of quality stocks over the last 12-18 months.”

Rick believes there were a couple of reasons why quality stocks didn’t protect portfolios last year, when growth stocks failed. These were:

1. Historically, quality companies are predominantly dominated by consumer staple businesses with long-term cashflows. In the past, these businesses would rely on technology that was much more capital intensive and cyclical, and often prohibitive to new entrants. But that all changed over the last decade with advancements in technology, enabling many businesses to become extremely capital light and cashflow positive. As a result, growth and quality began to be intertwined, so the fastest growing companies also became some of the highest quality companies. However, the subsequent impact on growth from higher interest rates, significantly affected these higher quality businesses.  

2. In an economic downturn, the earnings of quality companies would normally outperform lower quality companies. But this did not happen over the last 12-18 months due to the amount of cash released as part of global stimulus packages, as well as the flow-on effect of the Russian invasion of Ukraine on global markets, which resulted in higher energy prices. These factors helped to increase the earnings of these lower quality companies.

Rick believes that by understanding these key factors, investors can begin to better comprehend why quality stocks did not protect portfolios at a time when growth stocks underperformed.

According to Rick, some of the conditions that enabled low quality companies to not only survive but thrive over the last two years has been reduced. Companies that were able to live off ‘free finance’ during the pandemic were able to operate much longer than Harding Loevner had anticipated. But that ‘free lunch’ has now ended.

“What you need now in your portfolio are companies that can fund their own growth or have sensible growth that investors are prepared to invest in. These are the types of businesses that we own,” says Rick.

“We don’t believe tightening liquidity and higher interest rates are going to have a significant impact on these businesses. Instead, we actually think they might benefit by seeing a number of their competitors either leave the market or reduce their activities.”  

When it comes to investing, Harding Loevner believes there are a number of trends happening globally – particularly in the sectors of technology, healthcare, and industrial automation – which it believes won’t be impacted by short-term fluctuations in interest rates or a slowdown in global growth. According to Rick, businesses that are well positioned to take advantage of these trends are the types of stocks that Harding Loevner seeks to own.

At each step of the stock picking process, its team of analysts carefully review and analyse the market trends and data sitting behind these companies.

“We focus on the businesses,” says Rick. “We spend a lot of time talking to our competitors. We also have a diversified base of analysts. For example, we recognise that China is one of the biggest risks in terms of new businesses. As a result, we have three Mainland Chinese born analysts who help us go to this market and enable us to better understand it.”

Examples of quality businesses sitting in these three industry sectors that Harding Loevner particularly likes include:

Technology

1. Nvidia – a U.S. multinational technology company and a world leader in artificial intelligence computing. It has 78 per cent of the graphics processing unit (GPU) market, which are used in embedded systems, artificial intelligence, mobile phones, personal computers, workstations, and game consoles. 

2. Synopsys – a U.S. electronic design automation company that focuses on silicon design and verification, silicon intellectual property, and software security. Synopsys supplies tools and services to the semiconductor design and manufacturing industry.

3. Applied Materials – an American company that supplies equipment, services and software for the manufacture of semiconductor chips for electronics, flat panel displays for computers, smartphones, televisions, and solar products.

Healthcare

1. Abcam – a producer, distributor and seller of protein research tools to scientists.

2. Vertex – Vertex Pharmaceuticals invests in scientific innovation to create transformative medicines for people with serious diseases. It has developed a drug for cystic fibrosis that increases the lifespan of people with this condition.

3. Illumina – based in San Diego, California, Illumina develops, manufactures, and markets integrated systems for the analysis of genetic variation and biological function.

4. WuXi AppTec – a Chinese pharmaceutical, biopharmaceutical, and medical device company that provides a broad portfolio of R&D and manufacturing services that enable the pharmaceutical and healthcare industries to advance discoveries and deliver groundbreaking treatments to patients. 

Industrial Automation

1. Hexagon – headquartered in Sweden, this global provider of information technology solutions is involved in digital reality solutions, which combines sensor, software and autonomous technologies.

2. Schneider Electric – a French multinational that specialises in digital automation and energy management.

3. Rockwell Automation – A U.S. provider of industrial automation.

Despite the pullback in quality stocks over the last 12-18 months due to COVID pandemic cash and the Ukraine conflict, Rick says that over the long-term, quality will remain a great way to outperform the market.

“At Harding Loevner, we are able to provide consistent results for our clients by balancing our portfolio by using both growth and quality stocks,” he says. “We tend to do best in markets that are 0-15 per cent up and also in down markets, and that’s because our quality stocks protect us.

“So, despite the anomalies in markets over the last 12-18 months, we can take some comfort from the fact that as long as the bear market continues and the economy is challenged, the likelihood that quality businesses will outperform increases. Moving forward, quality will matter. That’s why our philosophy to investing hasn’t changed.”

As the global economy is likely to remain volatile, with tail risks coming from a potential escalation of the Ukraine conflict, as well as the relative strength of China’s re-opening recovery post-COVID, and the sustainability of emerging market debt, Justin believes global listed infrastructure remains well placed to meet this volatility due to its defensive characteristics and ability to generate attractive risk-adjusted returns

Rick Schmidt CFA is Partner, Portfolio Manager, and Analyst at Harding Loevner.

He spoke on the topic ‘Quality and growth investing: Where to from here?’ at the 2023 IMAP Portfolio Management Conference – Sydney.