Quality generally refers to a greater degree of stability and profitability, which is expected to generate higher or more predictable returns. Quality companies tend to outperform in tougher economic conditions, given their more stable and predictable earnings.

It has many aspects. They can relate to business models: a strong competitive advantage and a market-leading position – from uniqueness of product or offering, perhaps through barriers to entry such as knowhow, patents or brands – which in turn leads to pricing power.

This can be shown by consistently high profit margins and returns on invested capital, and strong cash generation.

The importance of high returns on invested capital is that they demonstrate that a company’s returns are above its cost of capital, enabling it to finance reinvestment to sustain its competitive edge and exploit growth opportunities.

Sustainability of a business model is another key attribute of quality. If a company’s products have a low risk of obsolescence then their future revenues are more predictable and can be valued with more certainty today.

Low levels of financial leverage (e.g. debt) and a good management track record are other hallmarks of quality.

Underperforming quality stocks

You could be forgiven for thinking that quality stocks, with their typically more resilient earnings, would’ve outperformed over the past year as the economic outlook has darkened. So why have they underperformed?

This stems from the fact that many, if not most, quality stocks are also associated with the ‘growth’ factor.

Growth stocks, which as the name suggests are expected to have higher than average earnings growth, performed strongly in the 2010s. At a time of historically low interest rates, investors on the hunt for better returns were willing to pay a higher price for the rising future profits of growth companies, which looked particularly attractive when discounted back to the present day using low discount rates.

This culminated in a ‘last hurrah’ during the Covid pandemic as already low interest rates were cut to the bone. In the post-Covid recovery, as inflation has spiked and interest rates have risen sharply, the value today of those future earnings has been rapidly eroded, and growth stocks have underperformed.

Overlap between growth and quality

The overlap between growth and quality companies is understandable. Quality companies typically generate an economic surplus — their profits grow faster than the growth rate of the broader economy and ahead of the cost of capital — and this surplus can be invested in growth opportunities at solid returns.

As we look ahead to 2023, we see a high risk of recession as monetary authorities in the US, UK and Europe prioritise conquering inflation over economic growth, against the background of energy and cost-of-living challenges.

This is a classic environment for quality companies to perform well in, as their earnings hold up far better than lower quality companies with less differentiation, more volatile demand for their products and services and weaker market positions. Quality tends to outperform when earnings are downgraded in anticipation of a slowdown or recession.

Valuation premia at high levels

However, valuation premia for growth companies are still at historically high levels despite the recent setback. With interest rates set to rise further into next year, there could be further pressure on those valuations. We therefore believe a sensible approach is to maintain a skew towards quality and defensive companies, while limiting exposure to higher valued growth companies.

Fortunately, there are pockets of quality companies that have defensive characteristics and resilient earnings in such sectors as consumer staples (for example tobacco), defence (benefiting from increasing NATO defence budgets post-Ukraine) and healthcare.

These companies have the pricing power that enables them to pass on higher raw material and labour costs to customers, and maintain their profit margins. We believe this quality-focused approach, with sensitivity to valuations, should protect portfolios as the risks grow of a UK and wider global recession in the months ahead.

Sanjiv Tumkur is head of equity research at Rathbones