May 22, 2023
The Fairlight investment strategy is focussed on uncovering quality businesses, buying them at attractive prices and patiently owning them for the long term. While some market participants believe in rotating portfolios to time entries and exits into certain sectors and styles, it is our view than an investor is best served by steadfastly owning a portfolio of wealth creating businesses. This view is informed not only by the experience of the investment team, but by historical data which suggests quality investing enjoys the favourable characteristics of not only long-term outperformance, but resilience in downturns and perhaps counterintuitively, rapid recoveries from drawdowns.
In this update, we will analyse the past four decades of returns data, using the MSCI World Quality Index (‘Quality’) as a proxy for quality. For the purposes of the index, quality is defined as stocks with high quality scores across three fundamental variables: high return on equity, stable year-over-year earnings growth, and low financial leverage. Other MSCI indices were used as proxies for the Value and Growth factors.
Quality outperforms over the long-run
When looking at long term returns, it is clear that Quality outperforms both the MSCI World Index and the Value and Growth factors (see Figure 1). Since 1981 Quality has delivered 12.2% annually compared to 9.8%, 9.5%, and 9.0% for Value, World and Growth respectively. Assuming $100 invested in 1981, this 2.7% annual outperformance from Quality over MSCI World has compounded out to a substantial $7,215 advantage to the patient quality investor.
Quality protects capital in downturns…
While the long-term outperformance track record of quality is compelling, it is the defensive nature of the return profile that is particularly appealing to long term investors who value capital preservation. Since 1981 there have been 10 negative returning years (downturns). In those years Quality has outperformed MSCI World 90% of the time by an average of 5% per annum (the only year Quality failed to outperform was 2022).
…and recovers faster
Notably, when we examine the five largest drawdowns over the period, Quality not only fell on average significantly less than the other factors but also recovered much faster with an average drawdown length of only 497 days.
Using the Global Financial Crisis as an example, Quality declined 42% (outperforming Value, World and Growth which fell 59%, 54%, and 51% respectively), however it only took Quality 791 days to recover its previous peak, compared to 1,473, 1,381, and 1,335 days for Value, World and Growth (see Figure 2).
When does quality underperform?
Unfortunately, there is no asset in financial markets that can deliver outperformance in all market environments. Quality for example generally underperforms during periods of surging energy prices such as the 1983-1984 oil crisis or the 2022 energy shock. This tends to happen because commodity extraction businesses (i.e. mining, oil & gas, energy) tend to perform the best during those environments and they do not meet the criteria for a quality business. While these lower quality businesses may benefit from short term spikes in earnings or a multiple rerating, the data indicates that over the long term this is ultimately outweighed by the compounding earnings power of Quality.
The Fairlight View
When we consider the historical data, we believe there is a compelling argument that any investor with a long-term time horizon who prioritises capital preservation should be invested in quality equities. At Fairlight this means investing in businesses that are competitively advantaged with conservative balance sheets, strong management teams and avoiding market timing or rotating the portfolio into different sectors or investing styles.