One of the best strategies during the last market regime was to buy quality large caps, as epitomised by Terry Smith. Quality is rather a flexible concept in investment – most people prefer to say they hold good businesses rather than trash – but broadly this meant companies with high return on equity, low leverage, and steady earnings that produce reliable cash flows and strong global growth prospects.
A decade ago, quality investors favoured areas such as consumer staples – often developed-market firms with exposure to emerging markets. Later, some of these stocks started to struggle amid slower emerging-market growth and the return of inflation after the pandemic, while the tech sector began to lead markets. So quality investors shifted a little towards software or data services, where the best businesses have steady recurring revenue, low capital intensity and the ability to lock in loyal customers.
Still, relatively few quality investors were drawn to Nvidia (semiconductors have always been a cyclical sector) and certainly not to firms such as Tesla. Since these stocks have had a huge influence over the last few years, quality has been unable to outstrip the market as easily as it did before the pandemic and many funds with this approach are doing less well.
A changing portfolio
You can see these shifts play out in Fundsmith’s history. In February 2015, the fund had 40% in consumer staples, by far its largest position. By February 2020, technology was the top sector at 29%, slightly ahead of consumer staples. Then last month, it held 32% in health care, with 20% in consumer staples. Fundsmith has been more flexible than some other quality strategies and the steady move into healthcare could help performance rebound if tech is reaching a peak.
However, the tricky question for quality large-cap strategies – not just Fundsmith – is whether the entire approach faces a much tougher environment. The last era was hugely favourable for large multinationals. Globalisation gave them the chance to expand into new markets around the world, while politicians and regulators were often very relaxed about waving through cross-border mergers and acquisitions. Big companies grew ever bigger and more profitable.
There are compelling reasons to think this may be over. In the short term, tariffs will mostly hurt firms that ship goods across borders, rather than services. But in the longer term, fragmentation and antagonism create a more hostile world for multinationals. The US slaps more tariffs on European goods. Europe cranks up regulation on US tech giants. The US strikes back against European firms… and so on in a vicious circle.
If this happens, the obvious conclusion is to favour local over multinational (and small over large). I don’t think that outcome is certain, and this volatile market is not the time to rotate out of large global defensives into small caps. However, investors should be alert over the next few years for signs that the trend has changed and quality large caps may no longer be a stand-out strategy.