BNY Mellon Investment Management: Four factors of quality

Walter Scott¹ client investment manager Murdo MacLean considers the key attributes he thinks quality companies should possess to be resilient over the long term, highlighting some of the themes and industries where he sees this at play.

Key points

• Long-term resiliency in a company requires it to possess certain hallmarks of quality.
• Artificial intelligence (AI) is one theme quality companies could leverage to become leaders in their field.
• Semiconductors and healthcare are two industries where companies are adopting AI to gain a competitive advantage. 

Companies with quality attributes that stand on the right side of global thematic trends are well placed to ride out short-term market volatility stemming from factors such as central bank interest rate decisions and global elections.

That is according to Walter Scott client investment manager Murdo MacLean, who argues companies that are likely to be resilient over the long term tend to possess four key attributes: high profitability; strong balance sheets; pricing power; and asset light business models.   

MacLean suggests these factors can cushion companies against unexpected issues, be it a pandemic, rising interest rates or global conflicts. He thinks over the long term, companies with these attributes tend to do well when markets rise but, perhaps more importantly, also stand to protect capital when markets fall.

“In the short term, markets can be driven by factors such as rates or conflicts, so you must accept that the best companies in the world won’t always outperform. But we expect the market to recognise quality over longer periods and we observe these companies tend to get stronger and we believe that they will outperform.”

MacLean says quality businesses typically have little debt, generate high levels of cashflow and tend to exhibit good growth. Not tying up capital to generate a return should also allow them to stay at the forefront of innovation, he adds.

But MacLean accepts there is no avoiding the fact that the market does have a short-term view and continues to “obsess” over rate cuts, creating uncertainty. “It has been a funny-old few years,” he says. “It remains a very challenging and unpredictable environment and consumers are feeling it – and if they are feeling it, businesses will be feeling it too.”

MacLean says the longer rates remain at higher levels compared with the past decade, the more pressure that puts on certain companies’ health. Owning quality companies is one way to protect against this potential fate, he adds.

Artificial intelligence

MacLean identifies artificial intelligence (AI) as a key trend likely to play into the hands of stronger companies. “To keep ahead and innovate, companies will need cashflow to invest heavily to make sure they stay aligned with the leaders in the space and overcome potential obstacles,” he says.

MacLean thinks we are in the “first innings” of an AI story set to run. He likens AI to a house, saying everyone is currently focused on the foundations but as with any house there are likely to be many elements of AI that come after the groundwork has been laid.

“I think as companies apply this technology and these tools to their businesses, they will get more profitable, more efficient and that will be across multiple industries, broader than just semiconductors and chip designers.

“There are a lot of companies that in the next five or 10 years will showcase what they can do. We would imagine that for a lot of those companies this will further enable them to entrench their dominance in their field.”

Semiconductors

MacLean suggests semiconductors is arguably the most important industry today. Termed the ‘new oil’² by some commentators, he observes there are huge barriers to entry from both a technological and capital perspective. But the proliferation of devices requiring chips, from smartphones and washing machines to aeroplanes and medical equipment, continues to propel the industry forward.

The semiconductor supply chain offers an interesting case study in deglobalisation, says MacLean. Amid the global reshoring trend, individual nations want to be able to own the whole chain but as things stand, that is not possible, he adds.

MacLean observes the design, software and equipment companies tend to be found in Europe, US and Japan whereas the design, fabrication, packaging assembly and test, and materials companies typically have more of a presence in China, Taiwan and South Korea.

“No single company can do it all as there are multiple companies involved in the chain,” he says. “Whether chips are made in Texas or Taiwan there will still be as many players. That is why it is so fragile – if one link goes wrong the whole thing falls.”

MacLean adds: “We would expect to see a greater degree of de-risking in these areas. But it is probably going to take at least 10 years before anything changes because all the equipment manufacturers need to move together.”

Opportunities

To play the semiconductors theme, MacLean says Walter Scott likes companies that own the technology and sell it on to others. He highlights chip manufacturer Taiwan Semiconductor Manufacturing Company (TSMC), saying it does not compete with clients and is dominant in its field. It also has a diverse revenue split, he adds, between the internet of things, high-performance computing, automotive and smartphones.

Elsewhere, MacLean flags Dutch lithography equipment manufacturer ASML. He notes it has a virtual monopoly because no other company on the planet makes the same equipment. He argues the company stands to benefit from the ever-greater demand from the internet of things and from consumers for everything to be faster and better. “You cannot just flick a switch and compete with it,” he says. 

The evolution of generative AI has been making headlines and one company MacLean observes is quietly progressing in this space is US computer software firm Adobe with its Firefly web application.

In the healthcare space, MacLean points to Intuitive Surgical which specialises in robotic-assisted surgery. He notes how the medical professional has progressed from open surgery in the 1950s through to minimally invasive surgery in the 1980s and robotic surgery in the 2000s. Now, Intuitive Surgical’s da Vinci 5 digital co-pilot can assist surgeons in real time – and uses AI to personalise the coaching for surgeons, both before and during surgeries.

“Using huge amounts of data, it can advise a surgeon on the best way to do surgery in real time. Used in 2.2 million surgeries in 2023³ there are at least immediately 50 million they could go after and there are more than 300 million soft tissue surgeries done each year⁴, so it’s a huge opportunity.”

The value of investments can fall. Investors may not get back the amount invested. 

¹Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

²Wall Street Journal. Chips are the new oil and America is spending billions to safeguard its supply. 14 January 2023.

³Intuitive Surgical. Investor presentation Q1 2024. 18 April 2024.

⁴National Library of Medicine. Trauma of major surgery: A global problem that is not going away. 29 July 2020