Investment Focus Quality-Driven Growth: An Enduring Combination Over the past several years, market observers and participants have focused to the point of obsession on the performance and possible trajectories of growth and value stocks. In our view, however, the quiet, steady dominance of a third style makes the debate beside the point. International quality stocks have consistently outperformed their regional growth and value peers for the last two decades. Quality-driven growth investing has been an enduring combination. Done properly, we believe it has the potential to identify companies across many sectors and industries with high levels of financial productivity, lasting competitive advantages, and reinvestment opportunities for growth. Collectively, we believe companies with these characteristics can deliver a consistent pattern of performance through different investment cycles. 2 Introduction market environments, with the notable exception of very strong rising markets, which tend to favor value stocks. When comparing against Study after study has shown that investors are not very good at timing growth, the MSCI ACWI ex-USA Quality Index has outperformed the market, but the conversation around style investing shows that its counterpart Growth Index in 96% of the three-year periods when they nevertheless spend an awful lot of time trying to do it. As growth growth was underperforming and 74% of the periods when it was stocks soared over the last decade-plus, pundits asked whether the outperforming. world had permanently shifted to favor high-growth technology stocks over businesses heavy on assets in the physical world, which often fall in the value category. But even very short periods in which value Exhibit 1 started to pull ahead elicited a frenzy of speculation about whether the Quality Outperformed International and US Benchmarks for valuations of growth stocks, many of which are not very profitable, the Last 20 Years had finally flown too close to the sun. Quality vs. the Broader Market in US and International Equities 1. 8 We propose that investors need not try to puzzle out the answer to any of those questions; they need only turn their attention to quality, an Cumulative Excess Return (Quality/International) oft-forgotten third style. Quality international stocks have beaten both 1. 5 the broader market and growth and value styles for the last 20 years (Exhibit 1). In what we think is a testament to the power of investing in high-quality companies anywhere in the world, the same pattern 1. 2 has held true in the United States. In some ways, it is understandable that the market focuses on growth Cumulative Excess Return (Quality/US) 0.9 and value despite the consistency of quality stocks’ performance. 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 There is a pleasing symmetry to the performance of the two styles over the last 20 years. In hindsight, value stocks were the best choice for As of 31 December 2020 Quality refers to MSCI ACWI ex-USA Quality Index; International refers to MSCI investors between 2000 and 2009, while growth stocks took the lead ACWI ex USA Index; US refers to MSCI ACWI Index. thereafter (Exhibit 2). The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices mentioned are unmanaged and have no When thinking about growth in the 2020s, however, it becomes clear fees. One cannot invest directly in an index. All data is in USD. Information and opinions presented have been obtained or derived from sources to us that deciding between these two perspectives isn’t strictly neces- believed by Lazard to be reliable. Lazard makes no representation as to their accuracy sary or even wise. Our analysis of three-year rolling returns suggests or completeness. All opinions expressed herein are as of the published date and are subject to change. there is no clear pattern to outperformance in growth or value stocks, Source: FactSet while quality stocks have outperformed consistently in all kinds of Exhibit 2 Value Led the ‘00s; Growth Took Over in the ‘10s 2000–2010 Was the Decade for Value 2010–2020 Was the Decade for Growth MSCI ACWI ex-USA: Growth vs. Value MSCI ACWI ex-USA: Growth vs. Value 1.2 1.8 12/31/00–12/31/10 12/31/10–12/31/20 MSCI ACWI ex-USA Value 6.59% MSCI ACWI ex-USA Growth 6.94% MSCI ACWI ex-USA Value 2.78% 1.0 MSCI ACWI ex-USA Growth 4.39% 1.5 +220 bps +416 bps 0.8 1.2 Cumulative Excess Return (Growth/Value) Cumulative Excess Return (Growth/Value) 0.6 0.9 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 As of 31 December 2020 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices mentioned are unmanaged and have no fees. One cannot invest directly in an index. All data is in USD. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. Source: FactSet 3 But let’s assume that we’re in the real world, and investors don’t have to stick with either value or growth; instead, they can switch their allocations at any time. Even an investor who was able to perfectly Even an investor who was able to time the switch to growth from value dominance in August 2009 would have done better investing in quality for the duration (Exhibit perfectly time the switch to growth 3). While the past doesn’t always promise a similar future, we believe from value dominance in August 2009 it does support the notion that the performance of quality stocks has been independent from that of either value or growth. would have done better investing in Still more data suggests that something special is at work in qual- quality for the duration. ity investing. While international data only goes back two decades, US data on quality stocks goes back to the 1970s, and the quality outperformance trend even holds up with a nearly half-century time horizon. Indeed, 1976 is the last time it would have been a bad time Financial productivity is crucial to long-term growth because it for investors with a long-term investment horizon to put their money generates the cash necessary for a business to reinvest in itself. The in quality stocks (Exhibit 4). right companies can seize on opportunities for growth, when led by the right management teams, who choose to reinvest in the business. The Definition of Quality Perhaps they build a new factory to add much-needed capacity, invest in research that can keep the pipeline of new products stocked, build Quality means different things to different people. MSCI constructs its out their sales force in brand-new markets, or expand into promising quality index by looking for companies with high and stable financial new product lines. We believe all of these choices and many others productivity and low financial leverage. However, any index is back- can actually help ensure that a high-quality, growing company keeps ward-looking: It can only tell investors which companies have been producing strong returns well into the future. high quality in the past. Our focus is squarely on the most financially productive businesses, as we believe high financial productivity is the Not every business can reinvest productively, however. Some mature driver of the earnings stability, cash generation, and low financial lever- businesses would only dilute the returns that made the business age that typify quality companies. But we also focus our fundamental attractive in the first place if they spent money on new factories or research on companies we think can likely continue to generate high increased the ranks of their sales forces. Such companies may be better returns in the future, creating the compounding effect that drives our off returning value to shareholders in the form of higher dividends quality growth approach. Lazard International Quality Growth invests or stock buybacks. We believe experienced investment teams must in 40 to 50 of the world’s most financially productive companies, assess both a company’s opportunities to reinvest in ways that stand which are generally sourced from the top 30% of all international com- to generate more cash flow in the future and the competence of the panies in terms of cash flow return on investment (CFROI). management to seize those opportunities. Exhibit 3 Exhibit 4 Quality Stocks Outperformed Both Value and Growth in the Quality Has Consistently Outperformed for Long-Term ‘00s and the ‘10s Investors Quality vs. Value/Growth Switch in International Markets Rolling 10-Year Returns (Annualized, %) 4 (%) 6 MSCI ACWI ex-USA Growth MSCI ACWI ex-USA Value MSCI ACWI ex-USA Quality 3 MSCI ACWI ex-USA Value until August 2009, then MSCI ACWI ex-USA Growth 4 2 1 2 0 0 -1 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 1985 1990 1995 2000 2005 2010 2015 2020 As of 31 December 2020 As of 31 December 2020 The performance quoted represents past performance. Past performance is not a The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices mentioned are unmanaged and have no reliable indicator of future results. The indices mentioned are unmanaged and have no fees. One cannot invest directly in an index. All data is in USD. fees.