Quality: Staying True

This is an interesting time to be a quality investor. Rising rates are not friendly to these bond-like equities with healthy dividends and steady growth. However, rates are rising enough to raise serious concerns among investors about high valuations and the narrow concentration of equity markets. Such fears make the safety of defensive quality stocks attractive.

There is a tipping point at which rising rates go too high, and the safety of quality begins to outweigh their rate sensitivity. Other than high growth stocks, at least while it lasts, few stocks like higher rates, but quality stocks have a history of proving resilient in a crisis. This is key to their attraction.

How serious is the move in bond yields? This is only the second time in history that the US 10-year yield has gone from under 4% to over 5.3% in 500 trading days or less. The only other time was June 2007, and we know what happened next. Meanwhile, French government bonds are at levels not seen since the 2011 Euro crisis, and U.S. mortgage rates are at levels last seen in 2001. Only China (black line) is seeing yields fall, as its deflation shock rumbles on.

Major Global Yields Since 2022

Some call this a normalisation after the abnormal zero-rate era of the 2010s; others call it a crisis. Either way, this is not a goldilocks market with low rates and low inflation. As a result, we are currently experiencing some of the narrowest breadth – i.e. a market with fewer stocks in uptrends – in 20 years.

Within quality, some areas are stronger and others weaker. Consumer stocks are struggling, but healthcare is doing well. Software was strong until early September, but has had a weak month since. Insurance likes high rates because they boost income in their bond portfolios, but not rising rates, because they reduce the value of those portfolios. These are complex times.

Healthcare, Staples, Consumer Discretionary, and Insurance

Above all, the challenge for long-term investors who are clear-eyed about the dangers inherent in fast-moving, highly valued AI and technology stocks is whether to chase expensive large-cap momentum or wait patiently for the winds to change.

Quality in the Long Run

While we are not immune to performance pressures, ByteTree Quality’s answer is clear. We will stay true to sound investing principles, and not chase the latter stages of a narrow, expensive rally. We may make changes around the edges – e.g. shifting more from consumer staples into healthcare - but wholesale changes are not in order. We own the strongest brands, the best products, run by the best management teams, at the most historic companies, with the cheapest valuations. It is rare to find all these advantages in a single stock, but across the Quality portfolio, they are in abundance.

We are not making decisions on macro, nor on government policy, or geopolitics. We are betting that buying the best companies when they are truly cheap (against absolute metrics, their own history, peers, and future expected cash flows) will be a winning strategy through thick and thin. The more we can align with the prevailing winds, the better, but we won’t go wrong sticking with great companies at low prices.