How quality and value can reduce risk

In investing it is just as important to understand where the risks are accumulating as well as potential buying opportunities.

With markets becoming increasingly concentrated and returns driven by a handful of AI-related names, even broad global indices present challenges for investors to maintain extensive diversification.

Schroder’s CIO Johanna Kyrklund points out that just 20 stocks account for 74% of the year-to-date return of the MSCI ACWI index.

But we are starting to see some early signs that the AI-momentum trade is running out of steam. Large cap US technology companies have been struggling at times, with Microsoft, Amazon, Meta and Alphabet each underperforming the S&P 500 index year-to-date.

Intriguingly Apple, which lacks an explicit AI strategy, recently saw its market value overtake semiconductor manufacturer Nvidia, to become the largest company in the world at over $5 trillion.

Other semiconductor companies have also seen a sharp reversal with SK Hynix seeing its US-listed shares fall by a fifth since listing in July.

Quality and value show signs of life

Beneath the surface there are signs of a rotation into a broader selection of companies which have quality characteristics, such as high margins and strong balance sheets.

Over the past month, the MSCI World Momentum index has lagged both the equivalent momentum and value MSCI indices, which has been something of a rarity over the last few years, when quality companies significantly lagging the benchmark.

Another sign of the broadening out can be seen by looking at the equal weighted version of the S&P 500 index which has moved ahead of the S&P 500 index over the past three months, making 9% versus 6%, respectively.

There have been false dawns before and a short-term move does not mean there will be durable shift away from growth and momentum, but some fund managers are making the case for quality and value.

Schroder’s Kyrklund observes: “The market is currently pricing very low growth into many exceptional companies.”

Kyrklund says that adopting a disciplined valuation approach can help investors steer away from euphoric areas of the market linked to the AI trade.

BlackRock’s chief investment officer Helen Jewell has argued that market leadership is broadening towards areas with stronger valuation support and stable profitability, such as healthcare.

Fund managers at Robeco and AQR argue there is an opportunity to reduce risk and increase diversification by investing in companies which have value and quality characteristics, or QARP (quality at a reasonable price).

Why are quality and value performing together?

Historically, periods of outperformance by value have been driven by distressed cyclicals and companies with poor balance sheets rebounding sharply. In other words, low quality companies.

What’s interesting is that recent leadership has come from profitable, well-managed companies trading on sensible valuations, rather than the stocks with rock-bottom valuations.

The macroeconomic backdrop is now more supportive of the move towards quality and value.

Higher for longer interest rates penalise companies with higher debts and weak balance sheets while also creating a valuation headwind for high growth firms whose cash flows are projected far into future.

Conversely, the QARP investment style favours near-term cash flows, high profitability and balance sheet strength.

Which UK companies screen well on QARP?

We have crunched the data using Stockopedia software to uncover UK companies with a market value above £300 million which have quality and value characteristics.

To meet the quality criteria, we stipulated that companies must show at least a double-digit return on capital employed over the long-term. This can be a signal that a company has a defensible edge against competitors such as a strong brand or unique product.

To meet the value criteria, we stipulated a forward PE (price-to-earnings) ratio of under 15 times, which is based on analysts’ one year ahead earnings estimates.

JD Sports ‘King of Trainers’

The largest company by market value to make the cut is sportswear retailer JD Sports Fashion.

Despite a challenging period of falling like-for-like sales growth, the company achieves healthy returns on capital reflecting structural scale and brand advantages.

The business continues to generate strong free cash flows which grew 36% year-on-year in the latest financial year.

In a signal of intent to step-up shareholder returns management announced a 20% increase in the dividend and a £200 million share buyback.

Dr Martens - back on the front foot

Iconic British bootmaker Dr Martens recently confirmed another strong year of profit growth in its 2027 financial year to the end of May, buoyed by robust US demand and its strategy to reduce discounts and improve margins.

Management reiterated a medium-term target of achieving mid to high-teens percentage operating margins, compared with today’s 10.4%.

Watches of Switzerland

Luxury retailer of Rolex and TAG Heuer watches, Watches of Switzerland reported (14 July) better than expected full year earnings driven by a strong performance in the US as affluent consumers snapped up its timepieces.

The retailer said the US which represents around half of group sales, offered significant growth potential and market share gains after notching up 24% sales growth.