Getting the best out of the quality factor in European equities

Talking Heads podcast with Carmine De Franco

Andrew Craig: Hello and welcome to this week’s BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing factors and factor investing and in particular the quality factor. I’m Andy Craig, Co-Head of the Investment Insight Centre, and I’m joined today by Carmine De Franco, who’s Head of Quantitative Equity Portfolio Management at BNP Paribas Asset Management. Welcome, Carmine, and thank you for joining me today.

Carmine De Franco: Great to be here, Andy.

AC: Our topic today is factor investing. What we mean by factors are the broad persistent drivers of risk and returns in financial markets that investment professionals use in quantitative portfolio management to explain why a particular stock may be behaving in a certain way. And the main equity style factors are growth, momentum, low volatility, quality, and value and size, or market capitalisation. Over the last 25 years, there are three types of factor investing – growth, value and quality – that have stood out due to the impact on performance that they’ve had at various phases of the economic cycle. Is that a fair representation of the main factors?

CDF: It’s true: those factors have been with us for decades and their performance has been going through different cycles. But in the end, what the investors are looking at is the ability to pinpoint companies that can deliver superior returns. In this way, they try to tilt their portfolios to get more exposure to individual factors when they have tactical views, but also broadly to capture as many styles of factors as they can. Of course, the returns should benefit over the medium to long term by the fact that those factors perform over the years. Having said that, it’s true that factors can go through periods of under – or outperformance and it’s important to understand where this performance comes from to make portfolio more resilient.

AC: And that’s what we want to talk about today and in particular about the quality factor, which refers to stocks with strong and consistent fundamentals. The quality factor is often described in academic literature as capturing companies with durable business models with sustainable competitive advantages, and it’s often categorised as a defensive factor, meaning it’s tended to benefit during periods of economic contraction. Is that a fairway of describing the quality factor?

CDF: It is. When we think about the word quality, you would expect companies with sound business model, mature models, companies that can withstand uncertainty, companies that can walk through the cycle by maintain their profits and being soundly managed. Given what we had, especially in Europe over the last couple of years, it’s fair to expect that quality companies should have had a nice or at least an interesting path towards generating return.

We went through the Covid crisis and then we went through the 2022 drawdowns and with all the uncertainty that was thrown at us over the last couple of months, that’s the kind of markets where you would expect that quality companies should deliver results, but that wasn’t the case at least in European markets.

AC: Let’s talk about that. Can you please talk us through the performance of European quality stocks relative to their benchmarks in recent years?

CDF: To say the least, over the last five years since Covid, it’s been a disaster for this factor. It’s lagging other factors, it’s lagging the benchmark. We’re talking about double-digit underperformance . The question that the investors are trying to figure it out why in market conditions where quality is expected to do well, the performance is going down. It is a puzzle of whether this is a short-term underperformance cycle or if there is something structural.

AC: Let’s talk about that. Why has quality underperformed in European stocks in the recent past? And what should investors think about doing to get the full benefits of the quality factor?

CDF: Quality is about selecting companies for certain characteristics – the profitability, equity ratios, return on equity. You try to screen the investment universe and pick the best companies. If you do this, you might end up with tremendous sector biases  like consumer staples, healthcare. If you carry tremendous overweights, underweights, all your performance can be washed out by those biases. In the last 12 months, if you decompose the performance, almost half comes from sector allocation. For  instance, the massive underweight in the financial sector and the overweight on the healthcare cost almost half of the negative performance. The key message is that you need to implement it in the most efficient way. Otherwise, the performance you would expect is not turning up.

AC: If we look back over the long run, what do periods in the past tell us about what might happen next to European quality stocks? Is there a pattern that we can talk about or identify?

CDF: We can draw some conclusions of the recent performance. I’m strongly convinced that factors deliver performance over the long term because they are related to economic and structural things. But once again, portfolio construction matters. Diversifying styles in the portfolio might make sense You mentioned value, momentum, low risk. It’s really important to build in an efficient way. It’s an interesting time to see such an important factor in investors’ portfolios be so discounted. It offers interesting opportunities.

AC: That’s a good summary. The message is we should not lose faith in the quality factor. Investors need to think about correcting any intrinsic biases when investing in quality and about diversification across investment factors. So, thank you, Carmine.

CDF: Thank you, Andy.

That’s it for this week’s episode of Talking Heads. If you’d like to learn more about our investment insights, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights at viewpoint.bnpparibas-am.com. We recommend subscribing to Talking Heads on your favourite podcast channel such as YouTube or Spotify. You receive your podcast episodes every week and if you like Talking Heads, please leave us a positive review and a nice rating. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Andy Craig, and Carmine Defranco, Head of Quantitative Equity Portfolio Management. Please do join us again next week. Until then, take care.