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This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by John Davi, chief executive officer and chief investment officer of Astoria Portfolio Advisors in New York City.
This isn’t the time in the cycle to take excessive risk. The easy money has already been made. Late-cycle economic forces combined with desynchronized global growth and a deteriorating earnings cycle means you need more defensive posturing across stocks and bonds.
We’ve long called for owning higher-quality stocks in 2019. Why? Companies with above-average return on equity (ROE)/return on assets (ROA), and with increasing or stable profitability should be rewarded more when earnings are declining.
Secondly, higher-quality stocks have historically outperformed lower-quality stocks (see chart below).
Source: Kenneth French Data Library, with data as of 12/31/17, WisdomTree.
Since 1963, the highest quintile of U.S. profitable companies has returned 11.63%, while the lowest quintile has returned 7.79%. Higher-quality companies have outperformed the market over this same time period as the market returned 10.30%.
Why Quality, Why Now
We’ve been looking for quality ETFs to take in more assets than any other factor in 2019, and year-to-date, U.S.-listed quality ETFs have already taken in approximately $2 billion in assets as of early February. Consider that the entire equity ETF universe has seen approximately $20 billion of outflows in 2019.
We like high-quality stock ETFs for the following reasons:
The earnings cycle is deteriorating, and companies with above-average ROE and increasing profitability are likely to be rewarded more on a relative basis.
The quality factor historically has been shown to be robust, pervasive and persistent over time.
Over the past five years, the global economy has had varying periods of acceleration and slowdowns, but the general trend has been cyclicals outperforming defensives.
Source: Bloomberg
Given the late-cycle economic pressures and a deteriorating earnings environment, defensive companies with higher-quality attributes will be rewarded more in 2019. If high-quality stocks performed well when the market was driven by QE and led by cyclicals, why wouldn’t quality work when the market shifts to a more defensive tone?
The quality factor is intuitive (i.e., it’s easy to understand), persistent (works across time class) and is pervasive (works across asset class).
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