The recent sell-off of software stocks has worsened the struggles of fund managers deploying a ‘quality’ investment strategy, such as Nick Train and Terry Smith.
With investors already rotating into value stocks, fears about AI disruption of previously reliable software and data businesses have compounded the pain. Smith’s Fundsmith Equity (GB00B41YBW71) invested in Relx (REL) rival Wolters Kluwer (NL:WKL) in December and added Sage (SGE) in January, right before shares dropped another 25 per cent. Train’s Finsbury Growth & Income (FGT) holds the likes of Sage, Relx and London Stock Exchange Group (LSEG).
Fundsmith this week also saw more than half (58 per cent) of shareholders in its struggling global small cap trust, Smithson (SSON), take a cash exit, losing the fund house nearly £1bn of assets under management. Smithson takes a quality growth approach, is managed by Simon Barnard rather than Smith himself, and is being turned into an open-ended fund. Boaz Weinstein’s Saba Capital, the US activist, held a 16 per cent stake in the trust.
Quality investing involves buying companies with resilient earnings, strong balance sheets and competitive advantages, which can grow even in challenging environments. The style outperformed for many years, but was more recently has been overtaken by value strategies, particularly in the UK and Europe.
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Kate Marshall, lead investment analyst at Hargreaves Lansdown, argued: “Quality has not been losing money, rather it’s not kept pace with a value rally.” She noted that in Europe and the UK in particular, defence stocks have been boosted by geopolitical tensions, and banks by higher inflation and interest rates, leaving other sectors behind.
James Carthew, head of investment companies at QuotedData, noted that quality stocks can be expensive, so if something goes wrong with their fundamentals, they have a long way to fall. “The hit from having something that looked like quality and turned out not to be is really quite significant,” he said. Recent examples include Diageo (DGE) in the UK and Novo Nordisk (DK:NOVO.B) in Europe.
“Quality does well in times of stress,” said Ben Yearsley, investment director at Fairview Investing. “Strong balance sheets, recurring revenue streams, defensible moats … that’s what you need when the world is going to hell in a handcart. And we haven’t had any periods in the last few years of major stress, with the exception of maybe the week around ‘liberation day’ last year.”
Marshall is optimistic about the long-term. “Investment styles naturally move in cycles,” she said. “Quality as a factor has demonstrated strong long-term performance and has historically proven more resilient during periods of economic stress or market turbulence.”
Yearsley agreed: “A major turnaround will come if the wider economy goes into a tailspin, forcing markets to rethink valuations.”
However, a quality recovery is likely to take time, particularly for software stocks. Mick Gilligan, head of managed portfolio services at Killik & Co, said it is “months away at the earliest”.
“I think lower interest rates would be helpful, and although this looks likely in the UK, it is much less certain in the US,” he argued. “We also need to see better visibility over the effects of AI disruption, and this probably comes in the form of consecutive earnings releases showing that sales and profits growth is not slowing.”
Funds
On top of Fundsmith Equity and the Lindsell Train vehicles, there are a number of funds and trusts using a quality approach across various geographies.
Within the Association of Investment Companies’ UK equity income sector, Edinburgh Investment Trust (EDIN) and Dunedin Income Growth (DIG) are the second- and third-worst performers over the past year, after Finsbury Growth & Income – albeit, they still posted gains of 11.6 per cent and 15.5 per cent in the year to 20 February, respectively.
Both tend to have a quality focus and hold some of the data and software stocks that sold off, including London Stock Exchange, and Relx, as well as traditional UK quality plays such as Unilever (ULVR) (Edinburgh) or Diageo (Dunedin).
Fund houses with a quality approach also include Troy Asset Management and Evenlode Investments. Their UK funds, Trojan Income (GB00BZ6CQ390) and IFSL Evenlode Income (GB00BD0B7C49), also hold significant positions in some of the stocks mentioned above, and were down 1.1 and 3.7 per cent respectively in the year to 23 February.
Yearsley said Troy was his “top pick as an investment house for quality”.
The house also runs a global equity income trust, STS Global Income & Growth (STS), which has almost a third of the portfolio in the UK and only 43 per cent in the US.
In the same sector, the much bigger JPMorgan Global Growth & Income (JGGI) also tends to like quality companies but is much more US-focused. Both trusts have had somewhat flat returns in the past year.
In Europe, a trust with a quality growth approach that has been struggling is BlackRock Greater Europe (BRGE), not helped by a large position in Novo Nordisk held until last year.
Gilligan said that in the current environment, “there are very few quality trusts that look highly attractive”. But he suggested Ashoka WhiteOak Emerging Markets (AWEM) and The Global Smaller Companies Trust (GSCT) for small caps.
