Atlanta - We believe a hallmark of high-quality companies is the financial strength to self-fund growth. Unlike lower-quality companies, they are less dependent on capital markets, providing a potentially significant advantage during Fed rate-hiking cycles. Following the past seven rate-hiking periods, higher-quality growth stocks have outperformed lower-quality stocks, longer term.
Fastest rate-hiking cycle in history, with further hikes expected
The fastest Federal Reserve (Fed) rate-hiking cycle in history continues to be absorbed in the economy. Amid the prospect of continued hikes, U.S. recession uncertainty, geopolitical risks and the impact of China's reopening, we expect market volatility to persist.
While U.S. stocks have broadly fallen over the past 14 months, low-quality stocks1 have seen the greatest price corrections, with their market multiples compressing the most. Higher interest rates have already hurt stock price-to-earnings (P/E) ratios, and we believe higher rates are likely to slow both economic growth and corporate earnings growth going forward.
Following a hot January jobs report, Fed Chair Powell signaled more interest rate increases will likely be needed to quash inflation. He indicated hikes of 25 basis points (bps) are probable in March and May, and said the Fed would be focused on and react to "the data."
Lagged effects of higher rates
The effect of higher rates takes time to work through the economy. Low-quality companies face a challenge when investors realize that the cost of capital will increase as rates rise and affect the firm's future-year costs.
In contrast, many high-quality companies are financially able to self-fund. Accordingly, many high-quality companies may experience smaller increases in financing costs, which can enhance their ability to maintain their growth and fund acquisitions.
Since May 1983, there have been seven Fed tightening cycles, lasting from nine months to the most recent 36 months from December 2015 to December 2018.
On the whole, higher-quality stocks (those within the Russell 1000® Growth Index with an SPGMI Quality Rating2 of B+ or better) have generated greater excess returns than lower-quality stocks (those within the Russell 1000® Growth Index with an SPGMI Quality Rating of B or below) over the 12, 24 and 36 months following the end of these hiking cycles.
Sustained earnings growth is key
We believe a key indicator of quality is sustained earnings growth. Rather than weighing macro, top-down factors, we look for companies capable of maintaining earnings growth through different market environments. We seek quality businesses with long-term growth drivers — elements we believe offer the highest return with the least amount of risk. Historically, these companies have demonstrated dominant franchises, strong pricing power, high margins, positive free cash flow, recurring revenue and strong working capital.
Earnings tend to drive stock prices over the long term, so they are a leading metric for investors. We look for companies with a history of stable, consistent earnings growth, preferably over the past 10 years. Over the past 30 years, higher-quality stocks in the S&P 500 have shown higher compound earnings growth rates and lower earnings variability than their lower-quality counterparts, with no periods of negative earnings (Display 2).2
We believe a focused portfolio of high-quality companies is best positioned to capture long-term, risk-adjusted value over a variety of market environments. In our view, this approach could prove increasingly valuable in times of macro uncertainty as these companies' market leadership and mission-critical products and services drive differentiated financial outcomes. We look for responsible, quality businesses priced below our estimate of intrinsic value with proven track records of consistent earnings and growth.
Bottom line: Higher-quality stocks are generally less dependent on capital markets for funding, providing a potentially significant advantage during Fed rate-hiking cycles. In our experience, companies with a clear track record of consistent growth, low debt and stable earnings may provide a "margin of safety" that can become increasingly valuable in periods of rising uncertainty.
Past performance is no guarantee of future results.
1. Higher-quality companies typically have consistent earnings, strong balance sheets, significant free-cash-flow generation, growing revenues and meaningful competitive advantages, whereas the opposite is true for their lower-quality counterparts.
2. The S&P Equity Quality Ranking system, now known as the SPGMI Quality Ranking, has data going back to 1956. S&P has graded the financial quality of several thousand U.S. stocks from A+ through D, based on the most recent 10 years of quarterly earnings and dividend data. The better the growth and stability of a company's earnings and dividends, the higher the quality ranking.
3. The High Quality Research and Low Quality Research portfolios are model portfolios formed and rebalanced monthly by Atlanta Capital. The universe includes all S&P 500® Index constituents with SPGMI Quality Rankings and prices greater than $1. Five-year historical earnings growth rates are calculated using a market capitalization-weighted methodology. The S&P 500® Index is an unmanaged index of large-cap stocks commonly used as a measure of the US stock market. Historical performance of the index and research portfolios illustrates market trends and does not represent past or future performance of the strategy.
Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000® Index is an index of approximately 1,000 of the largest U.S. companies based on a combination of market capitalization and current index membership.
Compound annual growth rate (CAGR) is the annualized average rate of revenue growth between two given years.