Quality headwinds

“If a business does well, the stock eventually follows.”

As the Sage of Omaha finally withdraws from the frontline of investing later this year, everyone has been keen to plunder his aphorisms, plentiful as they are. On the surface, the aforementioned quote is simple but, given space, it reveals many truths; not least about the long-term nature of investing (a painful experience for many seasoned fund managers) but also about the nature of investing philosophies and their interplay with markets.

It has been a particularly arduous period for quality investors in Europe of late, in no small part because Europe has started to attract global investor attention of a rare persistency, just as the style is in the doldrums. To clarify, it is not that investors have fallen out of love with an investment style that has performed admirably for decades. It is that on a relative basis to a market that has risen 18% since the post-Liberation Day lows, and 40% in three years, quality investors have lagged even when they have posted strong absolute returns. Another way of looking at the picture: over the last two years, the MSCI Europe Index has returned nearly 26.2%, the MSCI Europe Value Index has returned nearly 36.3%, and the MSCI Europe Quality Index has risen just 11.5%.¹ Hardly the most accommodating of environments.

We have repeatedly written about our aversion to labels or buckets, and it would be incongruous of us to begin using them now while chafing at circumstance. So, a more appropriate starting point would be to set out Quality as a concept. There is no universal definition, but we would suggest that a quality company tends to display the following three elements: high and persistent cash generation, high and sustainable returns on capital, and the opportunity (either organically or otherwise) for growth. These are by no means the only elements, but at the very least they represent the overarching theme that dominates the kinds of businesses that often fall into this category. Apposite industries include pharmaceuticals, consumer names (both staples and discretionary), and certain areas of the semiconductor industry. As investors who operate on a fundamental, bottom-up basis searching for businesses that can generate high and sustainable levels of profitability and compound shareholder value over time, we are often led to these ‘quality’ areas, though this by no means precludes others.

Philosophically we have always believed that over the long term (i.e. at a minimum a full market cycle, and between five and ten years) these sorts of businesses should outperform the market given their ability to compound shareholder value over time, their ability to withstand stress and strain from economic and market gyrations, and the fact that their innate competitive advantages and persistent return profiles allows them to adapt and take advantage of existing and emerging secular trends. That said, no investment style can outperform at all times and the last 18 months have demonstrated that.

Style cycle frameworks are a useful tool for analysing what part of the business or economic cycle one may be in. Often separated into different segments, the cycle can broadly be split into four elements which reflect differing periods of economic growth and contraction. Using the Bank of America Merrill Lynch (BAML) Style Cycle Framework² for example, these are labelled as Boom, Slowdown, Recession, and Recovery. Different asset classes and investment styles have historically outperformed during each different stage of the cycle which is to be expected given the feed-through to businesses from the broader economy. BAML’s framework currently suggests that we are in the Recovery stage of the cycle, a period where Value outperforms, as do low quality names, small caps and rising momentum names. This has been born out in markets of late as compressed risk premia, low unemployment, and high corporate profits, all combine for a risk-on environment where the demand for safety and quality is at a low. What is particularly interesting at the moment, however, is that this particular ‘Recovery’ stage has now been ongoing for 19 consecutive months, the longest on record.

However, at a sector level the devil remains – as always – in the detail. Pharmaceutical companies have faced idiosyncratic issues, stemming in part from the threats emanating from the Trump administration over pricing, resulting in a derating even though earnings and drug development pipelines are in a formidable position. Luxury goods businesses have suffered from a slowdown in China as well as a stellar run over the preceding decade. On the other side of the style ledger have been European defence stocks. The combination of a war on the border and the shakiness of the US guarantee to the bloc and NATO more broadly has meant the ramp up in defence spending commitments has resulted in extraordinary returns for the sector. Considering that this was one where most companies were sub-cost of capital only a few years ago, it is quite the turnaround.

Which leaves us at the following juncture: European quality stocks sit at a seven-year relative low, even after bond yields have fallen since the start of the year across many countries (quality stocks often move inversely to bond yields), and many are at historically low valuations. As investors, this presents a challenge: the age-old friction between adherence to an investment philosophy and riding the challenging performance periods and adapting to certain changes in the investing arena that may prove longer than expected. Or to put it another way, in case markets do remain irrational longer than you can stay solvent.

There are some suggestions that perhaps the underlying nature of businesses have changed to such an extent that quality is no longer what it once was. We are deeply sceptical of this idea especially given the points made earlier about the length of the current cycle. Some commentators now query whether all European banks are now quality investments in the longer term rather than just some of the more traditionally resilient and high-return businesses often found in the north of the continent. While we own many excellent banks across the bloc, we would always note that while cyclical, often leveraged businesses may look great during benign economic periods, the litmus test comes when economic headwinds emerge. In much the same way that concerns are prevalent over the private credit industry which has yet to experience a major macro downturn, we do not believe that companies can jettison their cyclicality so easily.

So, what to do in the face of such a stylistically unfavourable environment? The first is to exploit an investor’s skillset, namely fundamental bottom-up analysis. Does the investment case for each individual company still stack up? If so, a deeply unemotive analysis of a stock’s valuation is required to ascertain whether this is a buying opportunity, even when a company is out of favour. It is not a question as to whether these are excellent businesses. It is a question of disassociating a business from the market environment. The second is to reappraise all areas of the market to truly see if previously unattractive sectors from a philosophical perspective have indeed changed their spots, or whether they are merely masquerading. Finally, a rigorous use of risk tools that can help flatten style exposures relative to the market using both new and existing holdings can ensure that in periods where underperformance is likely, it is kept as small as possible.

Benjamin Graham once said that investing “isn’t about beating others at their game. It’s about controlling yourself at your own game.” In an investing arena that is contending with extraordinary levels of volatility both at a market and macro level, his words are more pertinent than ever.

^{1 Bloomberg, September 2025
2 Bank of America Merrill Lynch, 2025}

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