- RAHUL. G. KAPADIA, DESIGNATED PARTNER
DHEER KAPADIA FINSERV LLP
Factor investing is an investment strategy that involves choosing investments, particularly stocks, based on certain criteria such as value, momentum, low volatility, quality etc. For example, an investor using Value factor investing might create a portfolio that buys stocks that are cheap relative to fundamentals based on Price to Earnings ratio. A Momentum-based investment strategy would hold the top 20% of stocks based on last 12-month performance. A portfolio focussed on Low volatility would invest in the least volatile stocks and a Quality portfolio would own businesses with strong profitability, low debt and stable earnings. Factor based investment strategies tend to enhance potential for risk-adjusted returns compared to plain vanilla or market-cap weighted equity investing.
Different factors tend to perform well during different phases of the economic and market cycles. In a period of economic contraction where earnings fall and risk aversion rises, defensive factor strategies like Low volatility and Quality tend to outperform as investors prioritize capital preservation and stability. When the cycle turns, growth picks up and earnings rebound, Value strategies work well. When growth is strong, Momentum stocks tend to outperform. Late in the cycle when growth begins to moderate and valuations are high, Quality factor does well. Understanding which factors work in which economic environment can help investors tactically allocate and optimize investment outcomes.
In the current environment of downward pressure on growth and economic uncertainty, Quality factor investing can be a sound investment strategy. This is because high quality businesses usually have durable competitive moats, strong balance sheets and resilient business models which make them capable of better navigating adverse market environments. Downside risk of owning these businesses is thus lower than other styles and broader markets. Historically, Quality style represented by the Nifty 200 Quality 30 Total Return Index has outperformed in times of economic and market stress during 2010-11, 2015-2016, 2019-2020 and 2021-2022, providing better downside protection.
Some well-known examples of high-quality Indian businesses are a leading Information Technology services company with consistent cash flows, global clientele and high dividend payouts, a Fast Moving Consumer Goods company with high brand recognition and premium products, a company with a monopoly in the adhesives space, a leading private bank with strong asset quality and good management, a pharmaceuticals company with global contracts and high margins and an airline with the largest market share thanks to its low-cost, high service quality and punctual offerings. Quality businesses can thus be found across sectors and industries. Next, these businesses have to be screened for financial robustness on parameters such as Return on Equity, Return on Capital Employed, financial leverage, net cash balance and capital allocation. Further, the valuations of these high- quality businesses should be reasonable to make investment sense. Given that this style has underperformed in the last 5 years, now can be a good entry point to capitalize on quality available at lower prices.
Investors who wish to participate in equity markets during these uncertain times and prefer lower risk and stable returns can consider Quality-focussed mutual funds. These funds can help investors identify Quality businesses and invest in them at reasonable valuations. As with any investment decision, investors should consult their financial advisor to determine the appropriate allocation based on their goals and risk profile.
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