Once seen as a reliable way to compound wealth steadily over time, ‘quality’ has endured one of its toughest periods in decades, lagging broader equity markets from 2021 to 2025.

That experience has led some investors to ask an uncomfortable question: has quality investing stopped working?

Our answer is: no. But the recent period has been a reminder that quality doesn't win all the time. How quality is defined, valued and implemented matters just as much as the philosophy itself.

What do we mean by quality?

At its core, quality investing is about owning businesses that can create value for their shareholders over time. That typically means companies with strong profitability, robust balance sheets, durable cash flows and competitive advantages that allow them to reinvest and grow.

Over the long term, share prices tend to follow earnings and cash flows, not short term market enthusiasm. This is why quality investing has historically delivered attractive risk-adjusted returns across full market cycles, even if it can lag during more speculative phases.

However, the past decade also saw quality become a crowded label. As the style grew in popularity, definitions narrowed. Many investors came to rely heavily on backward - looking metrics such as low volatility, smooth earnings or headline returns on equity. In some cases, portfolios began to look remarkably similar – and increasingly expensive.

That matters, because quality bought at any price isn't a free lunch.

Why quality struggled from 2021 to 2025

The recent underperformance of quality strategies was driven less by a failure of fundamentals and more by an unusual combination of market forces.

First, the sharp rise in inflation and interest rates following the post-Covid rebound significantly increased discount rates used in equity valuations. Businesses with long-dated, predictable cash flows – a hallmark of quality – were treated like long-duration assets and saw valuations compress.

Second, markets experienced powerful cyclical rebounds that favoured lower quality, more leveraged companies with short-term sensitivity to nominal growth. In these environments, prudence and balance-sheet strength can be temporarily outbid by operating leverage and momentum.

Third, market leadership became exceptionally narrow. A small group of large technology and AI-related stocks dominated index returns, reinforced by the growing influence of passive investment flows. This concentration made it harder for diversified, quality-oriented portfolios to keep pace, even when underlying businesses performed well.

The result was an extreme period of relative underperformance for quality – one that has few historical precedents.

Underperformance is uncomfortable — but not unusual

Periods like this are challenging, both financially and emotionally. Yet history suggests that underperformance isn't a flaw in a disciplined investment strategy; it's an inevitable feature of it.

Styles go in and out of favour. When quality lags by a wide margin, it is often because markets are rewarding very different characteristics – leverage, speculation or narrative – rather than sustainable cash generation. Importantly, such extremes have tended not to persist indefinitely.

Past episodes where quality fell well below its long term trend were often followed by strong and durable recoveries as conditions normalised and fundamentals reasserted themselves. Mean reversion – the tendency for extremes to normalise over time – is not a precise timing tool, but it is a powerful force over full cycles.

Why the backdrop is becoming more supportive

Several of the headwinds that weighed on quality in recent years are now easing.

Despite conflict in the Middle East, inflation has moderated, and interest rates appear to be stabilising rather than rising relentlessly. That shift reduces the pressure on long duration cash flows and allows balance sheet strength and earnings visibility to matter again.

At the same time, market leadership is showing early signs of broadening beyond a handful of mega cap names. As speculative enthusiasm fades, investors tend to become more selective, focusing once more on profitability, cash generation and capital discipline.

Valuations also look more supportive. In many regions, the gap between the cheapest and most expensive stocks is wide by historical standards. That creates fertile ground for active investors to find high quality businesses trading at more reasonable prices – particularly where fundamentals remain intact, but sentiment has cooled.

Rethinking quality: beyond simple metrics

One important lesson from recent years is that quality cannot be reduced to a single screen or formula.

Headline measures such as return on equity or margin stability can be distorted by accounting choices, asset intensity or capital structure. Smooth earnings are not always a sign of resilience, and cyclical businesses are not automatically low quality.

Equally important are qualitative factors that are harder to capture in numbers alone: competitive positioning, pricing power, industry structure and – critically – management’s approach to capital allocation. Even the best business can be damaged by poor decisions, while sensible stewardship can add lasting value.

In that sense, quality is not ‘buy and forget’. It is ‘buy, monitor and reassess’, with a clear focus on whether a company continues to earn attractive returns on the capital it employs.

Quality forever – even if the label fades

It is possible that quality as a marketing label becomes less fashionable after a difficult run. But quality as an investment principle cannot disappear so long as markets function.

Ultimately, the fair value of any business is determined by its ability to generate cash for its owners over time. Long term investing, at its heart, is about buying those businesses at sensible prices and holding them through the ups and downs of the market cycle.

Quality investing may not deliver smooth returns every year. But history suggests that when it is defined thoughtfully, valued carefully and applied with discipline, it remains one of the most reliable ways to compound capital over time.

Quality does not win all the time. But over time, it still matters.