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The Busy Advisor’s Guide to Building Quality Portfolios

Scared of volatility? Rather than move out of equities, move up the quality ladder to invest in the best blue-chip companies in the world.

June 2022

Alfred Lee

CFA, CMT, DMS, Portfolio Manager & Investment Strategist

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Vishal Bhatia

CFA, Portfolio Manager, Exchange Traded Funds

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Key Takeaways

  • Quality factor screens for the best blue-chip companies around the world
  • Uses a systematic approach based on three distinct financial criteria: Return on Equity (RoE), Financial Leverage, Stable Earnings Growth
  • Poised to rebound strongly once central banks become less hawkish, potentially in the second half of 2022 and early 2023

What are the advantages of looking at global equities through the Quality lens?

AL The true beauty of the Quality lens is that it provides a simple way for managers to identify the best blue-chip stocks in the world. MSCI has conducted extensive research on this topic and, as shown below, the Quality factor has proven to historically outperform the broad market over the long term. It systematically allows us to find companies that have been leaders in their respective industries. Ultimately, we're seeking to identify the best of breed businesses, and that can be done with a rules-based index, screening for very similar metrics that Warren Buffett does when looking for companies he identifies as having “economic moats.”

Historical Performance (10 yrs)

Source: MSCI as of April 29 2022 and BMO Quality ETFs Making Sense of Quality Investing. Quality represented by MSCI All ACWI Quality Index TR, Broad Market represented by MSCI ACWI TR 10-year annualized return vs. the 10-year standard deviation. All returns in gross of fees and in USD.

Index returns do not reflect transactions costs or the deduction of other fees and expenses and it is not possible to invest directly in an Index. Past performance is not indicative of future results.

We know that not all Quality investments are made equal. What’s your definition of Quality?

VB We define Quality based on three main criteria: 1) high Return on Equity, 2) low Financial Leverage, and 3) Stable Earnings Growth. It’s important to note that these financial metrics are not chosen at random—MSCI’s research shows that they are key determinants of long-term performance. As Alfred mentioned, we’re also getting exposure to the risk premium associated with Quality in an efficient way by selecting from a large investable universe of over 1,500 names. Using our selection methodology, we then whittle down the list to several hundred stocks worthy of inclusion in the fund.

What kind of companies, sectors or geographies are typically captured by this Quality screen?

AL From a sector perspective, Technology currently has the highest weighting in the fund, followed by healthcare. In both cases, our methodology led us to their stable, consistent year-over-year cash flows. These sectors include “steady eddy” names like Alphabet (formerly Google), Microsoft and Johnson & Johnson, all of which function more like utilities than high-growth stocks with high financial leverage. The U.S. is our top-weighted region from a geographic perspective, but only because many of the world’s great businesses are domiciled there. We’re looking for the best companies internationally, and we don’t want to put borders on where they are earning revenue. Finally, it’s important to remember that a Quality strategy doesn’t require us to be tactical—we don’t have to worry too much about the market cycle, macro headwinds or headlines, because ultimately, we only hold companies that pass our financial screens. These types of businesses typically have sound balance sheets and tend to be more durable no matter the economic climate.

Are global equity funds designed to be core or satellite holdings in the portfolio?

VB By definition, the portfolio’s holdings have globally diversified income streams, which means they are better insulated from negative outcomes in any one region. This diversification component makes the fund incredibly attractive as a core holding. However, when thinking about global equities, it’s important to note that the composition is significantly different than it was 20 years ago. Emerging markets, for example, have evolved from being commodity-driven to being powered by a growing technology sector. With more weight given to names like Taiwan Semiconductor Manufacturing, one of the largest microchip makers in the world, investors get to ride the coattails of that impressive growth story and hedge against the tech giants in North America, which are vulnerable to rising interest rates. Longer-term, the global growth story still leans in favour of Emerging markets. And investors can now access a one-ticket solution to add that exposure up to their particular risk tolerance.

It’s been a rocky road for equity markets this year. What kind of risk-return profile can investors expect from the fund?

AL Despite having had a tough year, we’re confident in the fund’s long-term outlook. Of course, equities will likely be more volatile than most fixed income portfolios over the long term. But 2022 has been an outlier, with rising interest rates and high inflation driving down valuations in the tech sector and beyond. Nevertheless, it’s worth remembering that our fund invests only in blue chip, quality-growth companies that will likely rebound in due course. In fact, I would say this sell-off in quality has created a buying opportunity for quality names, which should be a tailwind for returns over the near to medium-term. The numbers clearly tell that story. The fund has: an average risk-versus-category, which shows how it resilient it is relative to the sector; a high return-versus-category, which demonstrates its solid earning potential; and, finally, a strong Sharpe ratio, which speaks to the well-balanced trade-off between risk and return. It is a well-oiled machine for Quality investing over the long term.

What’s your prognosis for equities for the remainder of 2022? Are there any sectors you’re keeping a close eye on?

AL While equity markets have come off quite a bit this year due to rising interest rates, we can expect the U.S. Federal Reserve to slow down its rate hike schedule in the back half of 2022, which could lead to a rebound. Fortunately, we only need the Fed to be a little less hawkish. Technology would be the sector most likely to outperform since they’ve suffered most from the rapid monetary tightening. Growth assets have a longer time horizon and all their future cash flows are discounted back to the present, so when there’s an increase in borrowing costs, the price of that future growth gets more expensive. Even the more stable, cash-rich tech names in our portfolio have been beaten up in recent months, which is why they’re well positioned to rebound when equity markets rally. Also, if we do head into a higher rate environment where growth is slower that should, by definition, benefit companies with less financial leverage (debt).

We often ask our portfolio managers to provide us with a book or podcast that our Advisor audience would enjoy. Did you have a recommendation?

VB I regularly listen to the Peak Human podcast, which is all about optimizing your health in a variety of ways. And I also enjoy Tim Ferriss’ podcast, as his takes on business and life are always informative and thought-provoking. In terms of books, I would highly recommend The Obstacle is the Way by Ryan Holiday. It’s about the ancient Greek philosophy of stoicism, and why being resilient in the face of adversity allows you to overcome challenges and turn every impediment into an opportunity. The author has tons of examples of famous historical figures using stoicism to their advantage, from the likes of John D. Rockefeller to Amelia Earhart, Ulysses S. Grant and even Steve Jobs.

Please contact your BMO Global Asset Management wholesaler for any additional support and guidance.

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