One of the most pronounced trends in the stock market since the global financial crisis has been the continued outperformance of “quality” companies.

Often found within the consumer, healthcare and business services sectors, these companies typically exhibit certain common characteristics such as dominant market shares, defendable business models with limited economic cyclicality, high returns on capital, and sustainable long term revenue growth.

In the FTSE 100, the likes of Diageo, British American Tobacco, Intertek and others have all strongly outperformed the market over the past three years. But are they still great investments for trusts today?

Superior growth

Let us first consider the reasons why this group of companies have performed so well. There are two interrelated drivers: superior earnings growth and valuation re-rating.

A weak economic recovery has played to the advantage of this group of quality companies. Due to their strong business franchises and lack of economic cyclicality, they have managed to continue growing their earnings, underpinning dividend growth and share price appreciation

In contrast, many of the more cyclical companies that would usually benefit from an economic recovery have struggled to grow their earnings in the current environment.

Valuation re-rating

In addition to the earnings outperformance, this group of quality companies has also benefited from a valuation re-rating.

The main driver for this has been a gradual shift in investors’ expectations. Expectations matter because the price that investors are prepared to pay for a share today is determined by expectations of the future.

And since the global financial crisis there have been two crucial shifts in investors’ expectations, both of which have favoured this group of quality companies. Firstly, the muted economic recovery has led investors to conclude that the low growth environment is now here to stay.

This implies any company still capable of producing sustainable earnings growth should be worth more relative to other assets.

Secondly, monetary authorities around the world have driven down bond yields to all-time lows, often lower than the (growing) dividend yields of these quality companies. This has served to increase the valuations of these companies as investors have sought higher yielding alternatives to bonds.

Economic recovery

Looking forward, there is little reason to assume a significant change in macroeconomic trends. Although there are some signs of economic recovery in the US and more recently in the UK, the basic problems of over indebtedness and forced deleveraging are likely to remain with us for the foreseeable future.

This will likely cap GDP growth rates at below trend, and hence favour companies that can still grow their earnings in this environment. However, there are significant risks to the second driver, the valuation re-rating.

Comparing the valuations of the group of quality companies with the rest of the market suggests that much of the change in expectations is now fully priced into the shares.

Quality companies with defensive business models are believed to be best placed to survive and thrive in the current difficult environment.

However, recognising that this view has become more and more consensual, we have been reducing and selling out of some of these companies where this is now fully factored into share prices.

Instead, look at underappreciated quality. These are companies whose business models and growth prospects are sound, but where the valuations do not yet reflect this.

One example is the media sector, in which there are many companies with strong and defendable business franchises.

For example, Reed Elsevier has market leading positions across the legal, scientific and medical publishing end markets, delivering steady low to mid single digit growth.

Before the global financial crisis, the shares were valued similarly to the consumer staples, but today they sit at a significant discount. This discount is expected to close over time as the company grows earnings and the shares re-rate upwards. Great companies are good investments, but only at the right price.