Rob Johnson, Head of Investments, Nedgroup Investments
Global equity markets have always rewarded patience unevenly, and the past year has underscored how quickly fundamentals can be discounted when incentives favour concentration over resilience. What distinguishes this period is not volatility itself, but how little tolerance markets appear to have left for error after an extended phase of narrow leadership and elevated valuations. Returns have clustered around a small group of stocks, market leadership has tightened, and pricing has stretched to levels that leave limited capacity to absorb disappointment. These conditions are uncomfortable but not unfamiliar, tending to emerge late in cycles when confidence rises faster than discipline.
Recent returns have been driven less by broad-based earnings growth and more by momentum, particularly in the US, where performance over the past year of 17%, followed two even stronger years of 25% in 2024 and 26% in 2023. Europe followed a markedly different path, with value stocks significantly outperforming growth and quality stocks. Style divergence of this magnitude is rare and deserves attention, not because it is unusual, but because it signals capital allocation under strain.
Periods such as these highlight the distinction between short-term outcomes and long-term returns, as momentum-driven incentives weaken the link between valuation and cash flow, rendering capital allocation increasingly fragile. Over time, that connection reasserts itself as the margin for error narrows and expectations adjust. For long-term investors, this is not simply a market observation, but a behavioural test. For investors focused on real returns, capital preservation becomes the natural starting point, reflecting arithmetic rather than ideology. Losses that permanently impair capital are difficult to recover from, particularly in an environment where future market returns are likely to be lower than those experienced over the past decade.
That behavioural test brings capital preservation into sharper focus, and with it the role of quality investing, which is often framed as a style choice but in practice reflects the economics of capital allocation over time. Businesses that generate high or improving returns on invested capital, convert earnings into cash, and reinvest that capital at attractive rates, tend to create value across cycles, regardless of the market backdrop. Returns on invested capital deserve sustained focus because two businesses can grow earnings at similar rates yet deliver markedly different outcomes for shareholders depending on how efficiently capital is deployed. Over long periods, companies with sustainably high returns on invested capital generate more free cash flow, rely less on external funding, and retain greater strategic flexibility when conditions tighten.
Growth plays a central role in this equation, and treating growth and value as opposing forces obscures how returns are generated in real terms. In an environment where costs persistently rise, businesses require a minimum level of growth just to preserve economic value. The distinction that shapes outcomes lies between growth that compounds free cash flow and growth that depends on optimism or the availability of cheap capital. Structural tailwinds can support this process, as digitisation, demographic change and infrastructure investment lift entire sectors, but tailwinds alone are insufficient. Execution, balance sheet strength and valuation discipline determine whether growth translates into sustainable shareholder returns.
Over the past year, this framework has been tested as quality stocks in Europe underperformed the broader market by a margin of 11%, while market concentration increased sharply in the US as a small group of technology stocks dominated index returns. The largest stocks now account for a disproportionate share of market capitalisation, a pattern historically associated with lower subsequent returns. At the same time, defensive and quality businesses have been materially de-rated, widening the gap between fundamentals and pricing. Over extended periods, share prices tend to follow earnings and cash flows. When valuations move too far ahead of economic reality, future returns are often pulled forward, leaving limited protection when lofty expectations are not met.
When valuation diverges from fundamentals, opportunity tends to appear first in areas where long-term demand is visible but temporarily obscured. Healthcare provides a clear example. Demographic trends are unambiguous: the global population aged 60 and over is expected to double by 2050, while healthcare spending as a share of GDP continues to increase despite short-term policy noise and post-pandemic distortions. Software presents a similar case, as concerns around artificial intelligence disruption dominate headlines even while enterprise systems remain deeply embedded within organisations. Systems of record are customised, integrated into workflows and protected by high switching costs, while data integrity, security and reliability carry greater weight for large organisations than novelty.
Valuation dispersion remains a defining feature of the current environment, with many high-quality businesses trading below their long-term median valuations while broader market benchmarks trade at premiums. In aggregate, the portfolio reflects an expected internal rate of return of around 13.5%, a high level relative to long-term history, despite a more cautious outlook for market returns overall. The long-term objective is to target returns of inflation plus 6 to 10% per annum over rolling five-year periods, not through prediction, but through careful underwriting of businesses capable of reinvesting capital at high returns. This approach accepts that periods of underperformance are inevitable, and that discipline takes precedence over keeping pace with momentum-driven markets.
Looking ahead, market returns are unlikely to remain as generous unless margins continue to expand, which history suggests is difficult to sustain. In such an environment, fundamentals regain influence, and earnings, cash flows and capital allocation drive outcomes once more. Quality businesses rarely announce their value loudly. They compound it quietly over time, often without attention. In markets shaped by extremes, discipline is not passive. It underpins sustainable returns and long-term stability.
ENDS
