Low-quality headwinds may create long-term opportunities September 3, 2020By Joe Hudepohl, CFAPortfolio Manager and Managing Director, Atlanta CapitalAtlanta - Thus far in 2020, equity market returns have been narrowly focused, led by a handful of obvious growth stocks — including technology and others that have benefited from what has transpired during COVID-19. Low quality has also dominated its high-quality counterpart.1 According to our analysis, over the year-to-date period ending August 31, 2020, low-quality stocks within the Russell 1000 Growth Index outperformed high-quality stocks by 24.5%. Index distortions and risksWithin the growth universe, we view concentration and valuation risks to be especially high. As of August 31, approximately 40% of the Russell 1000 Growth Index was concentrated in its top five stocks — Microsoft, Apple, Amazon, Facebook and Alphabet. The information technology sector alone accounted for 45% of the index — as distorted as it has been since the 2000 tech-bubble era. If we take into consideration some of the internet stocks that were shifted out of technology and re-categorized into communication services in 2018, this large-cap growth index looks to us like a technology sector fund — and not adequately diversified. From the perspective of managers who focus on higher-quality companies, such low-quality leadership has been a headwind for relative performance in the near term, but also provides longer-term opportunities to build portfolio positions. We have been especially active so far this year, initiating positions in businesses that we believe are attractively valued. A long-term lensDespite all this uncertainty, we do believe it is in times like this that our long-term investment horizon is of real value. While we don't know what is going to happen in the near term, we have much higher confidence that over the next several years the economy is going to normalize as a vaccine, treatment, and herd immunity diminish the risk of COVID-19. We believe that our high-quality companies are going to perform well in the meantime and reward investors over time. Our historical analysis suggests that high-quality equities tend to outperform over full market cycles and generally do well in periods of market volatility.Bottom line: The high concentration in the Russell 1000 Growth Index — along with the outperformance of low-quality stocks — has created some notable distortions in the market. We are taking advantage of the long-term, risk-adjusted opportunities we are seeing until the economy improves and conditions shift.1 Higher-quality companies typically have consistent earnings, strong balance sheets, significant free-cash-flow generation, growing revenues and meaningful competitive advantages, whereas the opposite is true for their lower-quality counterparts. Historically, high-quality equities have outperformed over full market cycles.