How To Invest In Quality Stocks

‘Allocate up to 20 per cent of your core equity portfolio to quality funds.’

The quality style of investing has taken a lead over the value style, which performed well until April 2024.

Between May and September, the Nifty 200 Quality Index outperformed the Nifty 200 Value Index.

“Due to heightened global and domestic economic uncertainty caused by geopolitical tensions, inflationary pressures, and supply chain disruptions, investors are seeking high-quality companies with robust financials and business resilience,” says Rajesh Cheruvu, managing director and chief investment officer, products and research, LGT Wealth India.

He explains that investors are shifting from growth and speculative stocks towards quality stocks, which offer predictable earnings and tend to perform well in challenging market conditions.

While value investing focuses on undervalued stocks that have the potential for price appreciation, quality investing favours stocks that have demonstrated sustained profitability, earnings stability, low leverage, healthy cash flows, and consistent dividend payouts.

Picking quality stocks

Quality investing is not limited to bluechip companies.

“Indices such as the Nifty Midcap 150 Quality 50 and Nifty Quality Low Volatility 30 show that quality can be identified across market capitalisations,” says Deepesh Raghaw, a Securities and Exchange Board of India registered investment advisor.

Gautam Kalia, head-super investor, Sharekhan, explains that a quality strategy evaluates companies on quantitative factors like balance sheet stability, and qualitative ones like management credibility.

“The broad definition of quality is those companies that have low debt, high return on equity (RoE) or return on capital employed (RoCE), and stable earnings growth,” says Arun Kumar, head of research, FundsIndia.

“Their key feature is consistency. They are companies that have demonstrated strong performance over long periods,” Kumar adds.

The Nifty 200 Quality 30 Index consists of 30 companies picked from the Nifty 200.

“These 30 stocks are selected using a scoring system based on predefined parameters, such as debt-equity ratio, earnings per share, etc,” says Kalia.

Quality outperforms in difficult times

Quality indices typically outperform during periods of economic uncertainty and market volatility.

“They also do well in range-bound and falling markets,” says Raghaw.

The resilience of quality companies makes them a safe haven.

“They thrive when investors seek stability over speculation,” says Cheruvu.

“In a strong growth environment, investors overlook quality. But when growth is uncertain, they gravitate towards these companies,” says Kumar. Value stocks, on the other hand, tend to outperform when liquidity is strong and volatility low.

Active or passive quality fund?

This choice should depend on risk tolerance, belief in market efficiency, and desire for potential outperformance.

Active fund managers can employ both quantitative and qualitative parameters to select stocks.

Passive indices choose stocks based purely on quantitative metrics.

“If you believe a skilled fund manager can identify opportunities and deliver above-market returns, go for an active quality fund,” says Cheruvu.

“But if you are unsure about which manager will maintain their focus, a passive quality index fund offers a safer bet,” adds Cheruvu.

How much to allocate?

Instead of focusing only on one style, experts recommend a balanced approach.

“Allocate up to 20 per cent of your core equity portfolio to quality funds,” says Kumar.

According to him, these funds should be complemented with a 20 per cent allocation each to value, momentum, mid and smallcap, and international funds.

By building a diversified portfolio and sticking to it for 7 to 10 years, investors can expect sound returns and a smoother ride, since one or the other style will do well at all points of time.

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Feature Presentation: Ashish Narsale/Rediff.com

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