While investing in high quality companies with strong earnings growth may seem like an inherently sensible way to invest and, even more intuitively, high quality infers safety. However, this strategy can actually backfire if taken to an extreme. The reason lies in a basic truth - valuation matters. Even the best business can be a poor investment if you pay too high a price.

In recent years, investors have increasingly crowded into stocks with robust growth profiles, stable earnings, and strong balance sheets. While focusing on quality is prudent, bidding up the valuations of these companies to extreme levels is not. When expectations get too high, even great companies can see their stock prices punished if growth slows or falls short of the rosiest projections.

On the flip side, apparently lower quality stocks, including more cyclical businesses with inconsistent earnings, are often shunned by the market and trade at discounted valuations. But at the right price, and at the right point in the economic cycle, these cheaper stocks can actually provide better returns with less downside risk than their high-flying counterparts.

This is highly counter-intuitive until one considers that beaten down value stocks often already have very low expectations built into their stock prices. So any incremental improvement in their business prospects can lead to outsized gains. With expensive quality growth stocks, the reverse is true - they must deliver exceptional results just to maintain their premium valuations.

History provides a case in point. After the tech bubble burst in 2000, cheaper value stocks dramatically outperformed despite their perceived lower quality, even generating double digit positive annual returns during a long, grinding economic recession. Meanwhile even cash flow positive established companies like Microsoft fell by 60-70% and didn't fully recover for a decade and a half later. Why? Because the quality growth darlings of the late 1990s had simply become too expensive. A similar trend played out after the Great Financial Crisis, when beaten down low quality stocks rebounded sharply.

Of course, this doesn't mean abandoning quality altogether. Investors still need to focus on companies with sustainable competitive advantages, healthy balance sheets and capable management teams. But valuation and market sentiment must be weighed too. Overpaying for quality is a risk not worth taking.

At InvestSense, we believe in maintaining exposure across investment styles, but emphasising those areas of the market that are less loved by the investing crowd. That means leaning into cheaper value stocks, while still maintaining select positions in reasonably priced quality companies. Going forward, we will continue to strategically shift our allocation as market conditions evolve.

The bottom line is that chasing popular stocks rarely leads to outsized returns, no matter how high their quality. By staying disciplined on valuation, and nimbly adjusting exposure as investment styles come in and out of favour, investors can position themselves for long-term success. Even if it means embracing the unloved corners of the market from time to time. The thing about less loved areas of the market is that they tend to be much less easy to bundle into a client friendly theme or narrative. With that in mind we will be spending some time with various fund managers over the next few weeks to substantiate the investment rationale for a disparate bunch of strategies in various less loved areas of the market ranging from smaller industrial Australian companies to, dare we see it, Chinese stocks.

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