The Quality Factor is Well Positioned to Outperform
The BMO MSCI USA High Quality Index ETF (ZUQ) provides an efficient way for investors to easily access a portfolio of high-quality, blue-chip companies that are well positioned for the current environment, but seem to have been unfairly punished by the recent sell-off in technology stocks.
Details:
BMO MSCI USA High Quality Index ETF (Ticker: ZUQ)
The BMO MSCI USA High Quality Index ETF (ticker: ZUQ) is down 16.0% year-to-date,1 with the quality factor moving in sync with the broad markets. This move comes despite focusing on companies with strong balance sheets and competitive moats, which are defined as having high return-on-equity (ROE), low earnings variability and low financial leverage.
Investing in businesses with strong fundamental characteristics – i.e., focusing on “quality” – should enable a portfolio of such companies to perform relatively well in times of rising inflation and increasing interest rates. Yet, year-to-date, ZUQ has materially lagged the S&P 500 Composite Index, mainly due to a higher information technology sector weighting. While the technology sector has been punished the most from inflation and rising interest rate risks, the tech positioning in ZUQ is structurally different than that of the same sector in the S&P 500 Composite. However, markets seem to be treating them the same.
Strong Earnings Under the Tech Hood of ZUQ
As of April 27, 2022, ZUQ possessed a 45.0% exposure to the technology sector. This exposure seems large, compared to the 27.0% technology sector weighting of the S&P 500 Composite. This difference is enough to explain the outperformance of our BMO S&P 500 Index ETF (ZSP) over ZUQ, based on the following argument: rising rates and inflationary pressures will diminish growth of the technology names and lower earnings expectations.
At the same time, earnings of many of the technology holdings of ZUQ are remarkably healthy, while earnings growth in the technology component of the S&P 500 Composite have been more volatile. The same headwinds facing the S&P 500 Composite tech sector have not hit the IT component of ZUQ as hard.
ZUQ - BMO MSCI US Quality Index ETF
| Ticker | Name | Weight (%) | Last Earnings Reaction |
|---|---|---|---|
| AAPL US | Apple Inc | 5.9% | Mixed |
| MSFT US | Microsoft Corp | 5.0% | Positive (Q1 2022) |
| JNJ US | Johnson & Johnson | 4.9% | Positive (Q1 2022) |
| UNH US | UnitedHealth Group Inc | 4.6% | Positive (Q1 2022) |
| MA US | Mastercard Inc | 4.2% | Positive (Q1 2022) |
| V US | Visa Inc | 3.7% | Positive (Q1 2022) |
| NVDA US | NVIDIA Corp | 3.5% | Positive (Q4 2021) |
| FB US | Meta Platforms Inc | 3.1% | Positive (Q1 2022) |
| LLY US | Eli Lilly & Co | 2.7% | Positive (Q1 2022) |
| COST US | Costco Wholesale Corp | 2.5% | Positive (Q1 2022) |
| Top 10 Holdings | 40.1% | ||
Source: Bloomberg, as of April 27, 2022. The portfolio holdings are subject to change without notice. They are not recommendations to buy or sell any particular security.
Fundamentals Matter
A prime reason for the stronger financial results of these companies is the robust fundamental characteristics, collectively called “quality” – i.e., companies with competitive moats, strong balance sheets and low leverage, among other characteristics, are typically less affected by macroeconomic risks than fledgling, less diversified companies valued largely on future growth potential. Painting the technology names in ZUQ and those in the S&P 500 Composite with the same brush is then misleading.
As the table below shows, tech companies in ZUQ have higher cash ratios, compared to the IT names in the S&P 500 Composite. While ZUQ has a higher technology weight than the S&P 500 Composite, it is focused on a handful of technology companies exhibiting stronger fundamental characteristics than the broad sector in the market cap-weighted S&P 500 Composite. The higher cash ratios and lower debt also means that the carry costs of debt are less punitive as rates rise and refinancing becomes less risky. Furthermore, the strong competitive moats of the companies in ZUQ allow them to have stronger pricing power, better able to pass on rising input costs to the end consumer.
| Fund | Tech Sector (%) | # of Names | Wgtd Avg. Tech Cash Ratio | Median Cash Ratio |
|---|---|---|---|---|
ZUQ (MSCI USA Quality) |
45.0% |
36 | 1.33 | 0.90 |
| ZSP (S&P 500) | 27.0% | 75 | 1.16 | 0.66 |
Source: Bloomberg, as of April 27, 2022; the weighted average cash ratio is of the information technology sector component of the respective fund.
Vulnerable Only on Paper
Given the low leverage ratios, strong earnings, and a more fundamental approach to selecting names in the technology sector, ZUQ should be well positioned to outperform the broad market in the current environment of rising rates and inflationary pressures. The main risks prevalent in the financial markets as of late are less likely to negatively impact names exhibiting quality characteristics than those with classic growth characteristics. The higher information technology weighting only makes ZUQ more vulnerable on paper. The companies under this umbrella exhibit some almost consumer staple-like characteristics – offering products and services that are essential in today’s society and generate handsome, consistent profits for the firms that offer them, thus making them quite different than the broad technology sector.
The BMO MSCI USA High Quality Index ETF (ZUQ) provides an efficient way for investors to easily access a portfolio of high-quality, blue-chip companies that are well positioned for the current environment, but seem to have been unfairly punished by the recent sell-off in technology stocks.
1 Bloomberg, BMO Global Asset Management, to April 27, 2022.
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