The rise of premiumization has significantly reshaped consumer spending habits, fostering a cultural shift where individuals increasingly prioritize quality products over standard offerings. Consumers today are no longer willing to compromise; they seek superior experiences, lasting value, and reliability in every purchase. Whether it’s choosing basic necessities, a high-performance gadget, or an exclusive service, the focus is on quality and durability, rather than just affordability.
This shift reflects a broader change in mindset—earlier, consumers often sought cheaper options in pursuit of immediate cost savings (akin to the Value Factor in investing), but now, they increasingly prefer durable, long-lasting products that ensure sustained benefits over time, much like the Quality Factor in equity investing. This shift highlights a fundamental desire for long-term returns on investment, whether in material goods or financial decisions.
A similar philosophy applies to equity investing, where the Quality Factor as an investment strategy is closely aligned with this trend of premiumization. Just as discerning consumers opt for premium products with superior craftsmanship and reliability, investors seeking long-term financial rewards may have to look beyond low-cost, average stocks and instead focus on high-quality companies with strong fundamentals. The Quality Factor screens companies based on profitability, financial leverage, and accruals, ensuring that only financially healthy and consistently performing businesses are included in the Quality Index.
What defines Quality?
Factor definitions—including size, momentum, volatility, growth, and value—have long been viewed with a high degree of consensus among practitioners and academic researchers. However, Quality, either as a factor or as an investing style, is a notion that lacks a universally agreed‑upon definition.
In India, NSE and BSE, the two leading stock exchanges, use Return on Equity (ROE) and financial leverage (Debt-to-Equity) as key indicators to assess the quality of companies in their indices. However, their approaches differ slightly. NSE considers earnings per share (EPS) growth stability, making its methodology more aligned with global index provider MSCI. BSE, on the other hand, incorporates the balance sheet accruals ratio, which is similar to the approach used by FTSE Russell.
Beyond these measures, analysts often use additional financial metrics to identify high-quality companies. These include Return on Assets (ROA), Return on Capital Employed (ROIC), Net Income Margin, Gross Margin, and Free Cash Flow Yield. Among these, a strong cash flow yield, captured through the accrual’s ratio, has been recognized globally as a key driver of returns. This suggests that firms with better cash flow management and earnings, quality may often outperform others over time.
How Quality fared in one of the longest Bull Run (2020 – 2024)
Factor-based investing has become a popular strategy for investors seeking to potentially outperform broader market indices and provide investors with an edge in varying market conditions. Calendar Year Return Quilt of Factor based Funds
The BSE Quality Index has delivered an annualized return of 22% over the last five years, as of 31st December 2024, outperforming its parent index, the BSE Large Midcap, by 4.01%. Analysing individual years, quality stocks performed particularly well in 2020 and 2022, delivering returns of 26% and 13%, during periods when the markets were in the path of recovery after a steep fall due to pandemic waves and global macroeconomic events.
Over a longer term also, the Quality strategy has outperformed its parent index in 72% of the calendar years. This level of consistency highlights the potential benefits of investing in Quality factor, which focuses on financially robust companies with stable earnings and strong fundamentals. On an average, other factor strategies have, outperformed their parent indices only 63% of the time.
While all factor strategies have their place, Quality has shown resilience in the past, with consistent performance over the long term. This shows that Quality is not just another factor—it may prove to be a preferred approach for long-term outperformance.
Quality remains steady while maintaining an edge in past
The BSE Quality Index has shown relatively stable excess returns over time. While other factors exhibit more pronounced peaks and troughs, quality maintains moderate yet positive excess returns in most periods. It has delivered daily excess rolling returns on a one-year basis in 72% of the time relative to its universe, just behind the Momentum strategy, which has outperformed 76% of the time. The Quality factor remains resilient during periods of economic uncertainty (e.g., 2008 financial crisis, 2011 debt crisis, and 2020 pandemic), highlighting its ability to provide stable returns.
Quality seemingly tends to generate a return advantage in mid-cycle or less directional markets, particularly when a scarcity component emerges. This growth scarcity was evident after the first half of 2024 and also in the period preceding the pandemic when economic and earnings growth were muted. These conditions led to a visible divergence in quality factor returns. As with any scarce commodity, when growth becomes harder to find, investors may prefer to pay a premium for high-quality assets.
Quality tends to thrive when market dives
Companies with robust financial metrics are typically better equipped to navigate challenging economic conditions and recover quickly as the broader market stabilizes. During uncertain times or early recovery phases, investors often gravitate toward financially stable companies with proven track records.
The Momentum factor has historically outperformed during bull markets, aligning with its reputation for performing well in rising markets. Conversely, the Value factor demonstrated its strength during the recovery phase, outshining every other factor and proving its resilience when valuations are bruised. However, the sharp negative returns experienced during bear markets nearly erode the wealth created by these factors in the bull and recovery phases, highlighting their cyclical vulnerability.
The Quality factor emerges as a consistent and stable performer across market cycles. In bear markets, it experienced cumulative returns of -27%, slightly inferior than the Low Volatility factor, which, by its very nature, is designed to experience lower drawdowns.
Interestingly, during the recovery phase, the Quality factor delivered a cumulative return of 41%, second only to the Value factor. This consistency may make it an intriguing choice for investors seeking balanced performance across market cycles.
How Quality factor competes with Quality focused Active investing
Passive investing using the quality factor and active quality-focused investing share the same goal, identifying high-quality stocks with consistent performance. However, their approaches differ significantly.
Passive quality investing relies on a predefined, systematic approach using 3-4 well-defined ratios like Return on Equity (ROE), Debt-to-Equity, and Earnings Stability. Active investing, on the other hand, involves a broader range of ratios and qualitative factors such as management quality or market sentiment, which can lead to over-analysis and decision fatigue.
Quality as a factor in passive investing removes human bias by focusing solely on quantitative data. Interestingly, the systematic and disciplined approach of passive quality investing has, at times, matched or even outperformed active strategies.
While quality focused active investing emphasizes detailed analysis, the streamlined focus of passive investing using the quality factor often provides a more reliable and unbiased alternative, indicating that simplicity is often the ideal choice at times.
Conclusion
Quality investing therefore emphasizes durable business models, sustainable competitive advantages, and strong financials, making this factor suitable for investors seeking long-term returns and during times of volatility. With India’s growth potential, focusing on quality can be advantageous, offering both return potential and downside protection in the evolving landscape.
Further, in the last 6 months of 2024, we have witnessed a turn of events in favour of quality over value stocks. Many of the investment-related themes like railways, defence, and PSU banks have experienced a beating, while a number of the quality cyclicals like NBFCs, consumer discretionary and auto have shown stronger performance.
In this evolving scenario, investing in quality-focused strategies may offer investors access to forward-thinking strategies targeting high-growth opportunities in sectors that could play a key role in shaping India’s future, making such avenues extremely timely and fruitful.
Disclaimer – This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The Stocks mentioned herein is for explaining the concept and shall not be construed as an investment advice to any party. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this article are as on date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article. While strong financial metrics can offer insights into a company’s performance, past performance is not indicative of future results. Investors are advised to carefully read the scheme information document before making any investment decisions. Factor-based investing involves risks specific to each factor and may lead to underperformance in certain market conditions. There can be no assurance that the objectives of the investment strategy or the factors discussed will be achieved. Investors should consult with their financial advisor before making any investment decisions. It is further important to note that past performance is not indicative of future results, and all investments carry risks.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
