Equity Roundtable

Quality features are an integral part of a long-term equity strategy that can surmount short-term challenges. In this roundtable, three chief investment officers of AllianceBernstein’s US equity portfolios discuss their approaches to identifying quality stocks and explain why they think quality will ultimately perform well again despite a difficult 2022.

Stocks with quality features haven’t performed well during the 2022 market downturn. Can you explain why, and why do you think quality will reassert itself in the future?

Frank Caruso, Chief Investment Officer, US Large-Cap Growth: In our view, this year’s market sell-off was quite anomalous in that it was initially driven by higher inflation and rising interest rates, rather than broader macroeconomic growth concerns. As inflationary pressures proved to be more persistent, that necessitated higher interest rates, which then put upward pressure on equity discount rates and downward pressure on valuations. These forces supported out performance of value stocks while disproportionately impacting growth stocks. Quality characteristics like balance-sheet quality and profitability were largely disregarded as investors flocked to cyclicals, and later, defensives. In the tail end of the first half, investors grew increasingly fearful of the implications of tighter monetary policy and higher rates on broader economic growth. Our belief is that as the market environment becomes increasingly challenging, quality factors—namely, growth, profitability and balance-sheet quality—will come back into vogue as investors recognize the importance of sustainable growth drivers in the absence of economic growth.

Jim Tierney, Chief Investment Officer, Concentrated US Growth: Frequently, companies that are high quality are rewarded with higher price-to-earnings (P/E) multiples. This year, multiple compression in the market is as severe as I can remember, given the Fed’s aggressiveness in raising interest rates. So, investors sold high P/E stocks without much regard to quality or earnings growth. Microsoft is the poster child for this—consensus analyst forecasts call for earnings growth of 10% this fiscal year after the company posted 16% growth in the fiscal year that ended in June. However, the shares have still declined by almost 30% year to date through early October. Quality will eventually reassert itself, most likely when the Fed nears the end of its rate hikes and investors assess the economic damage caused by this policy. We believe that companies with more durable earnings prospects, frequently associated with quality characteristics, should outperform in that environment.

Why is a focus on quality important in your portfolio approach, and how do you apply quality in your stock-picking and risk management processes?

Dan Roarty, Chief Investment Officer, Sustainable Thematic Equities: We seek to own high-quality companies aligned with sustainable themes that can outperform consensus expectations over time. To us, quality is linked to the creation of economic value. Firms create economic value when they deploy incremental capital at rates of return above their cost of capital. They destroy value when their incremental returns are below their cost of capital. High-quality businesses are typically characterized by some combination of durable growth, higher profitability, lower risk (strong balance sheets, higher business stability, etc.), competent leadership and strong competitive positioning. But not all high-quality firms have the same mix of characteristics or pursue the same strategies for economic value creation. The common denominator is, however, the creation of sustainable economic value. We target high-quality companies by focusing on longer duration and less cyclical sustainable investment themes and by forecasting our valuation models out five years into the future. Further, we assess the quality characteristics mix on an individual basis, instead of having a blanket approach and targeting one or two quality factors from a quantitative perspective. The payoffs to owning higher-quality businesses accrue over longer periods of time through the power of compounding.

Frank Caruso: We care about not just whether a company grows, but importantly, how a company grows. Our highly risk-aware approach is focused on identifying companies that have a high and improving level of profitability—measured by return on assets and return on invested capital—and have ample opportunity to reinvest those profits back into the business. By self-funding their longer-term growth aspirations, these companies should exhibit lower levels of cyclicality and macro sensitivity, and greater control over their fundamental destinies. We believe this should lead to greater fundamental compounding, which should support a smoother path of returns and better risk-adjusted results for investors over time.

Just as we care very much about how a company grows, we also care very much about how we initiate new positions and how we manage risk around existing positions. We aim to maximize risk-reward opportunities when initiating new names. This sometimes requires patience as we wait for more favorable engagement prices before starting a position. Similarly, when selling a stock, we aim to be disciplined in reducing or exiting positions for one of three reasons: if our thesis is invalidated, if a stock contributes too much to our active risk or if the risk-reward has grown less attractive.

It’s this disciplined process, philosophy and sell discipline, in our view, which underpins the quality of the portfolio and our approach to growth investing.

Jim Tierney: We ask a very fundamental question: Do we want to be in this business, with these people? That is closely tied to the quality of the business and the quality of the management team. We can’t anticipate every twist and turn in the environment over time. But when we own a healthier business with a top-notch management team, we believe the odds for success are greatly tilted in our favor.

Can you provide an example of a portfolio holding that reflects your quality approach? And can you provide an example of a popular growth company that doesn’t meet your quality criteria, and explain why not?

Jim Tierney: The animal health business has been in favor the last few years as pet adoptions soared during COVID. But not all companies are the same. Zoetis stands out to us for its innovation, ability to execute and differentiated sales force. The company also has many of the leading livestock and companion animal medicines on the market today. And in our view, it keeps widening the moat with innovation that competitors struggle to catch up to. The company also has a competitive advantage in its growing sales force, through which it gets more face time with vets and ranchers, at a time when rivals are cutting sales personnel.

A popular growth company that doesn’t meet our criteria would be Uber Technologies. While we understand that it can take time for growth companies to reach profitability, at some point a company that can’t generate earnings becomes “profitless prosperity.” Uber seems to be in that trap, in our view. And when we look at the economics for its drivers, we don’t see a sustainable business model. If driverless cars ever become a reality, the rideshare business model might transition toward Mercedes-Benz, Tesla or BMW and away from the current participants.

Frank Caruso: Vertex Pharmaceuticals is a biotechnology company whose leading drugs treat cystic fibrosis (CF). Our thesis for Vertex is centered on the ability to grow its CF franchise. Patent protection for Vertex’s CF drugs lasts into the 2030s, which, along with a strong efficacy/safety profile, creates a durable competitive advantage for the company, in our opinion. The combination of profitable growth, which is rare in biotechnology, and management’s discipline, reduces the likelihood of a dilutive acquisition for the purpose of boosting revenue growth—a behavior that plagues much of the industry. Vertex Pharmaceuticals is one of only a handful of biotechnology firms to successfully, and internally, discover and develop more than four drugs. With that historical success in mind, there are several compounds in Vertex’s pipeline, which in our view, offer additional long-term growth optionality.

Tesla is an example of a popular company that does not currently fit our philosophy. While the company has a large reinvestment opportunity, it has only recently become profitable. This is best illustrated by a tweet from Elon Musk in November 2020, where he stated that, at its worst point, Tesla was about one month away from bankruptcy as the company scaled production of the Model 3 between 2017 and 2019. As we know, automaking has traditionally been a highly competitive, capital intensive, low profitability business. Add on the significant increase in competition as traditional automakers shift their focus towards zero-emission vehicles, and at current lofty valuations, we believe the risk-reward opportunity looks quite unfavorable.

Dan Roarty: Danaher is a prime example of consistent economic value creation. It benefits from durable secular growth as a key enabler of advancements in medical innovation through its ties to synthetic biology. The company provides synthetic DNA instruction sets, tools for developing new applications and bio-processing equipment to produce products like more complex bio-tech drugs. It also reported strong return on invested capital in 2021 and we believe the company is well positioned to generate high free cash flow this year. Danaher has stable business drivers, a stronger balance sheet than many peers and history of accretive M&A, which offers long term growth optionality. And its total shareholder return has outperformed the S&P 500 over every single rolling three-year period from 1997 to 2021.

In contrast, Carvana is a popular growth company with low-quality characteristics. Although the company is the fastest growing online used car marketplace in the US, Carvana is not attached to a key secular growth trend, in our opinion, and is exposed to a weakening consumer environment. Low profitability and a weak balance sheet make the company unattractive to investors with a quality focus.

Why is an active fundamental approach to quality important when building a growth-oriented or sustainable portfolio? Why not just buy a passive portfolio focused on quality factors?

Jim Tierney: Everyone has a different view of how to define quality. For example, some equity factors view balance-sheet expansion as a “negative” to quality. And a passive strategy linked to these factors, would steer you away from companies exhibiting balance-sheet growth. In our portfolio’s approach, an expanding balance sheet driven by high-return projects, which are supportive of growth, is a huge positive. That’s because it can help drive core organic growth, which to us is an essential ingredient in a quality business. To identify sustainable quality businesses, we believe there is no substitute to meeting management teams, asking them hard questions and assessing if they are going to be great stewards of our clients’ capital. Passive approaches or models just don’t have that rigor and as a result, I believe they may miss true high-quality growth companies.

Dan Roarty: As mentioned before, quality looks different across industries and business models. It would be incredibly difficult to create a blanket “quality” score to generate a passive screen. Great businesses deploy capital at reinvestment rates above their cost of capital for long periods of time. Great stocks offer strong return potential because their operating performance exceeds consensus expectations.

It is not enough to only assess the “quality” of a business, investors must also understand the operating expectations embedded in the price of a stock. Analysts must identify the expectations that are most important for each company—they will not necessarily be the same for all companies, even competitors in the same industry.

There is no commonly accepted definition of “sustainability.” And the lack of data and inconsistent reporting requirements means it is very difficult to build a sustainable portfolio passively using quantitative screening. An active and transparent approach to defining sustainability and identifying relevant securities, like our framework aligned with the United Nations Sustainable Development Goals, is essential to building a robust sustainable portfolio.

Frank Caruso: Equity investing has grown increasingly complex in recent years as benchmarks became more concentrated. And recently, the reversal of accommodative fiscal and monetary policy has removed a key source of support for markets. Higher interest rates and inflationary pressures are creating new challenges for companies. Across sectors and industries, companies face higher borrowing costs as rates rise, which may slow economic activity and is also creating currency headwinds as the dollar strengthens. Put differently, we believe many investors have yet to adjust earnings forecasts to reflect this escalating uncertainty, even in sectors where share prices dropped sharply. And prevailing earnings expectations were set in an environment of unusually strong profitability, which still looks unsustainably high. Every company’s success in navigating this market will vary and, for investors, these challenges will require a keen focus on quality and selectivity.

The challenge with passive factor exchange-traded funds (ETFs) is that there is no single definition of quality. Each ETF will emphasize different characteristics, often leveraging backward-looking approaches to identify companies that meet their definition of quality. So, what is intended to be a passive decision in investing in a low-cost factor approach, actually turns into an active decision given different approaches and often significant levels of dispersion in returns and fees across strategies. Additionally, factor funds are typically single factor focused and do not integrate multiple factors to build a more robust perspective on quality.

Given increasing uncertainty for companies and investors alike, we believe that emphasizing a forward-looking rather than a backward-looking approach is going to be of paramount importance. With a disciplined, bottom-up fundamental research process, investors can establish the appropriate context for each company, develop a better assessment of the sustainability of a company’s growth and profitability, and offer a clearer assessment of risk and reward. This is the best way for equity investors to successfully navigate uncertainty ahead, as the impacts of central bank tightening become clearer, and position a portfolio for a future recovery.

AB portfolios cited in this article hold the following weights in the companies mentioned as of September 30, 2022:

The value of an investment can go down as well as up and investors may not get back the full amount they invested. Capital is at risk. There is no assurance that a separately managed account will achieve its investment objective. Separately managed accounts are subject to market risk, the market values of securities owned will fluctuate so that your investment, when redeemed, may be worth more or less than its original cost.

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