Mitigating Risks With Quality Investing Amid Volatile Markets

By Ihab Dalwai,

After a strong rally since March 2020, markets saw a sharp correction between September 2024 and March 2025, with benchmark indices falling 15–25 per cent. A recovery began in April 2025, but volatility is likely to persist. This is because the unknown impact of the still-evolving US trade tariffs on businesses around the world, geopolitical challenges, slowing corporate earnings momentum and a weak global economic cycle are all factors which can play spoilsport.

Factory capacity utilisation as reported by the RBI has started moderating from 75 per cent earlier to about 70 per cent in recent quarters. Corporate profitability has touched 5 per cent of GDP in FY25 – a level at which it usually starts moderating. In this uncertain environment, it is prudent to focus on high-quality companies with strong profitability, cash flows, and return ratios. Such companies usually tend to have strong brands, economic moats, entry barriers, and consistent product or service excellence.

Why Consider Quality?

In the post-pandemic period, the stimulus measures announced by the government, along with low interest rates sparked a strong growth phase for 3-4 years. During this period, while most style factors did well, quality as a strategy underperformed. The advantage of an under formed style is that there is lack of investor interest and less crowding which makes valuation reasonable.

Historically we have seen that quality as a style does well in a globally uncertain environment and also when we are in a phase of moderate earnings growth. This is because quality stocks generally tend to offer predictable and less cyclical profits and cashflow which market tends to prefer in such an environment.

Filtering for Quality

At ICICI Prudential Mutual Fund, we follow a three-step selection process. First, we apply a quality filter, looking for companies with high return on equity (ROE), return on invested capital (ROIC), financial leverage, a net cash position, and effective capital allocation strategies.

Second, these companies tend to have barriers to entry such as a strong brand image, large customer base, product or service excellence, sustainable profitability, and reinvestment potential.

The resultant stocks represent the quality universe, many of which may have expensive valuation thus presenting the danger of overpaying for quality. This brings us to the third step i.e. Buying quality at a reasonable price. Any investment decision is made only if the stock is available at a reasonable valuation.

Such a process offers flexibility to move across sectors and market capitalisations, take concentrated exposures when there are attractive opportunities, and follow both top-down and bottom-up stock selection processes as may be suitable to the market conditions. It is a myth that quality companies are available only in defensive segments (IT and FMCG). We believe quality companies are available across sectors (banks, non-banking finance companies, autos, retail and pharma) which enjoy superior financial metrics.

For Challenging times

Quality as a strategy generally tends to work especially well in a flat market environment and bearish phase. For instance, during falling market phases of August 2015-February 2016, September-October 2018, June 2019-March 2020 and October 2021-June 2022, the Nifty 200 TRI fell 13-34 per cent. In contrast, the Nifty 200 Quality 30 TRI fell only 11-24 per cent in those periods.

During February 2021-June 2022, October 2021-February 2023 and January 2011-June 2013, the Nifty 200 TRI was flat, delivering -1 per cent to 4 per cent returns, the Nifty 200 Quality 30 TRI gave 0-10 per cent returns in this phase. This clearly shows quality theme’s ability to limit downside and capture the upside reasonably over the long term.

Proven record

For the 20-year period (April 2005-March 2025), the Nifty 200 Quality 30 TRI gave CAGR of 17.9 per cent, while the Nifty 200 TRI managed only 14.3 per cent. Rs 1 lakh invested in April 2005 would have grown to Rs 26.8 lakh by March 2025.

The quality index also scores on consistency. When 5-year rolling returns are taken from April 2010 to March 2025, the quality index delivered a CAGR of 17.4 per cent on an average, while the Nifty 200 TRI delivered a CAGR of only 12.4 per cent. Additionally, the quality index never gave negative returns on 5-year rolling basis over April 2010-March 2025.

So, today if an investor is looking for an equity scheme, then they may consider a quality style based offering given its potential for downside protection during market downturns while maintaining the potential for steady capital appreciation over time.

(The author is Senior Fund Manager, ICICI Prudential AMC)

(Disclaimer: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.)