Quality investing in developed non-US markets has run into a strong headwind. After more than a decade of durable outperformance, the highest-quality segments of the MSCI EAFE universe lagged sharply over the year ending April 2026, while lower-quality, more cyclical names led the index higher. The reversal was most acute among compounding and franchise businesses, and it reopens a familiar question for allocators: does a single year of weakness signal a structural problem or a cyclical one? Many managers describe their portfolios as high quality, yet those portfolios differ widely in both composition and performance. The reason is that quality is not one factor.
This study examines four distinct quality approaches (Compounder, Franchise, Resilience, and Improving Quality) and analyzes their sector exposures, regional biases, risk characteristics, macroeconomic sensitivities, and long-term performance. Each leads to meaningfully different exposures and outcomes over time.
The findings carry four implications for allocators: treat quality as multi-dimensional rather than a single factor; evaluate it across full market cycles rather than on short-term performance; maintain valuation discipline even in the highest-quality businesses; and weigh manager selection carefully, since managers emphasize different dimensions of quality and can therefore look very different from one another. We develop each point in the closing section.
Defining Quality
Although quality is often treated as a single investment style, the evidence suggests it consists of multiple distinct factors that are only partially correlated.
To study these differences directly, we built four factor groups that mirror the approaches we most often see among non-US quality managers. Each is defined by a set of fundamental signals: persistently high returns on capital (ROIC), strong reinvestment, and durable growth for Compounders; high, stable margins and pricing power for Franchises; high and stable earnings with low leverage and strong interest coverage for Resilience; and improving returns on capital and margins for Improving Quality. The universe is the MSCI EAFE index, and the analysis runs from December 2006 through April 2026. For each category we rank every constituent on the relevant signals and select the top decile, rebalanced monthly. For the within-sector and within-region analysis later in the paper, we instead compare the top and bottom quality quintiles to isolate the return to quality in each segment. All fundamental and return data come from FactSet; portfolio construction and analytics are Xponance’s. Chart 1 summarizes the four approaches, how each creates value, and the tilts each tends to produce.
Two points stand out. First, these categories are not interchangeable labels for the same companies; because each rewards a different signal set (persistent returns on capital, pricing power, earnings durability, or the rate of fundamental improvement), they select genuinely different businesses, sectors, and regions. Second, the degree of overlap varies: Compounder and Franchise portfolios share considerable ground, Resilience sits almost opposite them, and Improving Quality behaves differently again because it targets change rather than level. These differences are clearest in where each approach actually invests, which the next sections examine.
Sector and Regional Differences
Structural Sector Tilts
Each quality factor tilts structurally toward particular sectors, so managers who emphasize different definitions end up with persistently different sector profiles. Charts 2 through 5 compare the sector weights of each top-decile portfolio against the MSCI EAFE index.
Compounders
The top-decile Compounder portfolio has carried a persistent overweight to Health Care and Consumer Staples for the past decade, reflecting the concentration of high-ROIC, stable-growth businesses with strong reinvestment opportunities there. Technology has grown in importance since late 2020, first through capital-light software and IT-services companies with recurring revenue, and more recently through AI-infrastructure names, particularly semiconductors.
Franchise Businesses
The top-decile Franchise portfolio resembles the Compounder portfolio but carries a markedly larger Health Care overweight, underscoring both the overlap and the distinction between the two. The Franchise approach weights industry leadership, pricing power, and margin sustainability, traits common among leading Health Care companies with high barriers to entry and differentiated products.
Resilience
The Resilience portfolio carries a pronounced Energy overweight, especially since 2022, driven by the sector’s improved margin stability and balance-sheet strength. This is not simply a commodity-cycle story: much of the stability reflects a structural shift after the 2014 to 2020 energy bear market, as companies adopted capital discipline, reduced leverage, and prioritized shareholder returns. Smaller, persistent overweights to Utilities and Communication Services (mainly telecommunications) round out the portfolio, their stable cash flows and defensive balance sheets fitting the Resilience criteria.
Improving Quality
Unlike the other styles, the Improving Quality portfolio shows no consistent sector pattern. Exposures rotate across cyclical sectors as fundamental improvement emerges in different parts of the market, consistent with a methodology that targets change in business quality rather than its level. Recent examples include Energy since 2020 (improving profitability and capital discipline), banks in 2023 (higher rates lifting profitability and returns), Materials in 2024 (better capital efficiency and a commodity recovery), and Utilities since 2024 (investment and earnings tied to AI-driven power demand).
Regional Exposures
The same forces that drive sector tilts also drive sharply different regional exposures. Continental Europe is home to many of the world’s durable compounders and franchises, global leaders with pricing power and high returns on capital, but historically offers less pure earnings stability or balance-sheet resilience. Japan is the mirror image: its companies have long combined high, stable earnings with strong balance sheets, yet returns on capital were depressed by overcapitalization and limited shareholder focus. That has begun to change, as governance reform and a renewed emphasis on capital efficiency lift Japanese ROIC and shift the market from a resilience story toward an improving-quality one. The UK sits between the two, anchored by franchises with pricing power and, over the past three to five years, improving returns on capital and earnings stability.
These structural differences map directly onto regional tilts. Compounder and Franchise quality skew toward Continental Europe, where pricing power and capital compounding concentrate (Charts 6 and 7). Resilience has historically skewed toward Japan and the Pacific Rim, with their stable earnings and strong balance sheets (Chart 8). Improving Quality has rotated toward the UK and Japan as reform and operational improvement take hold (Chart 9).
Performance of Quality Approaches
How have these structural differences translated into returns? Each approach carries its own tailwinds and headwinds. Compounder and Franchise portfolios, concentrated in high-multiple, capital-light businesses, thrive when discount rates fall and growth is rewarded, but suffer when rates rise or leadership rotates toward cyclical and value names. Resilience is built to protect capital under stress: stable earnings, low leverage, and strong balance sheets should lag in risk-on markets but hold up when conditions tighten. Improving Quality has no fixed sector bias; its returns depend on the market rewarding fundamental change, which tends to lead in cyclical recoveries and post-restructuring situations. Chart 10 and Tables 1 and 2 show the long-run profile; the analysis that follows decomposes returns by sector and region to test whether each approach behaved as designed.
Over the full period, Compounder has delivered the strongest returns, followed by Franchise. Resilience produced the lowest excess return but also the lowest downside capture (Table 2), consistent with its defensive design. Over the past year, however, Improving Quality overtook Franchise on a cumulative basis.
The recent picture looks very different. In 2025 and year-to-date 2026 the two long-term leaders posted their weakest relative results of the sample, with Franchise trailing the index by roughly 26% in 2025 and Compounder by close to 9% (Table 1). Resilience was the standout, adding meaningful excess return as investors rewarded stable earnings and strong balance sheets at higher rates, while Improving Quality held up better than either premium-quality approach. In short, the past eighteen months rewarded the opposite of what Compounder and Franchise investing emphasizes.
Performance Within Sectors
Aggregate returns can obscure where quality actually pays off: a manager can hold the right sectors yet add or lose value depending on which companies within them they own. The charts that follow plot the excess return of the top-quality quintile versus the bottom-quality quintile within each sector, over both the most recent year and the full period. If quality is a persistent source of return, the top quintile should outperform across most sectors over the long run despite the recent reversal. Comparing the two windows shows whether that reversal reflects a breakdown in the quality premium or a cyclical swing.
Compounders
- Over the recent year, top-ranked Compounders underperformed broadly, with the widest negative spreads in Software, IT Services, and Consumer Discretionary.
- The lowest-ranked names outperformed across much of the market, especially Energy, Materials, and Financials, as investors favored cyclical businesses.
- Over the full period the pattern reverses: the top quintile generated substantial excess returns over the bottom, led by Technology, Industrials, and Materials.
- The contrast captures the style’s central trait: valuation compression can drive sharp short-term underperformance, yet persistently high ROIC and durable growth have rewarded investors over a full cycle.
Franchise
- Top-quintile Franchises followed a path similar to Compounders, but their recent-year underperformance was even sharper.
- Many industry leaders were seen as less direct beneficiaries of the AI investment cycle, and some software franchises also face the risk that AI erodes their competitive positions.
- Over the long run, Franchises have nonetheless delivered strong excess returns, supported by durable competitive positions, resilient profitability, and high returns on capital.
Resilience
- Resilience was the near-mirror image of Compounder and Franchise: over the recent year, top-ranked names outperformed broadly while the bottom quintile lagged.
- The divergence reflects a higher-rate environment that rewarded stable earnings, resilient cash flows, and strong balance sheets, the traits that ease a higher cost of capital.
Improving Quality
- Leadership rotates among the cyclical industries where fundamental improvement is strongest.
- Top-ranked banks outperformed since 2022 as higher rates lifted profitability, and Energy delivered strong excess returns in 2022 and again year-to-date through April 2026, aided by commodity dynamics and structural change.
Performance Within Regions
The same decomposition across regions shows where the reversal was concentrated. Quality dispersion varies by region as well as by sector: the gap between the best and worst quality stocks can be far wider in one market than another. The charts below repeat the top-versus-bottom-quintile comparison by region, over the recent year and the full period.
- The broad patterns matched those across sectors, with clear regional differences: the rally in lower-quality stocks under the Compounder and Franchise lenses was far more pronounced in Japan and the UK than in Continental Europe (Charts 15 and 16).
- The broad patterns matched those across sectors, with clear regional differences: the rally in lower-quality stocks under the Compounder and Franchise lense The broad patterns matched those across sectors, with clear regional differences: the rally in lower-quality stocks under the Compounder and Franchise lenses was far more pronounced in Japan and the UK than in Continental Europe (Charts 15 and 16).
- That divergence came less from weakness in top-quintile names than from the strong outperformance of bottom-quintile companies in Japan and the UK, which led those markets.
- This explains the recent struggles of traditional Compounder and Franchise managers: focused on durable advantages, high ROIC, and stable profitability, they hold few of the lower-quality names that drove index gains, so they lagged where speculative or cyclical segments led.
- Resilience, by contrast, performed well in both the UK and Europe (Chart 17), as investors rewarded stable earnings, strong balance sheets, and resilient cash flows amid elevated rates.
Factor Correlations
If the four approaches truly capture different dimensions of quality, that should show up in their return correlations: approaches that select the same companies would correlate highly, while those rewarding different signals would not. We measure each category as the return spread between its top and bottom quality deciles, over the full period and the trailing five years.
Correlations across the four groups are generally modest and, in several cases, negative (Tables 3 and 4). Resilience is negatively correlated with both Compounder and Franchise; Improving Quality is only weakly correlated with the others; and even Compounder and Franchise, despite overlapping drivers, are only moderately correlated. Quality, in other words, is not a single factor but a family of return drivers with distinct economic exposures.
Correlations With Other Style Factors
Quality does not exist in isolation from the other factors that drive equity returns. How each category relates to value, momentum, and low volatility helps explain its behavior across regimes and how it might combine with other exposures. Table 5 extends the analysis to these style factors.
The relationships are far from uniform. Compounder and Franchise quality are negatively correlated with value and positively with momentum, reflecting their tilt toward highly rated, recently winning businesses, with a slight positive tie to low volatility. Resilience is the exception on every count: it overlaps with value, correlates negatively with momentum, and is negatively related to low volatility, because it rewards stable, strong-balance-sheet companies rather than expensive growth. Improving Quality again stands apart, with only weak, mixed ties to any single style. For allocators, a portfolio’s effective value, momentum, and volatility exposures depend heavily on which kind of quality its managers pursue; blending Resilience with Compounder and Franchise strategies, for instance, can offset some of the value and momentum bets embedded in the latter.
Risks in Quality Investing
Even a well-constructed quality portfolio carries risks, and they differ by approach. Two stand out. The first is valuation risk: the premium the market assigns to durable, high-return businesses can compress sharply when rates rise or growth expectations fade, and it falls most heavily on Compounder and Franchise strategies. The second is mistaking cyclical strength for structural quality: businesses that look highly profitable at the top of their cycle but lack durable earnings. We examine each in turn.
Valuation Risk: Primarily Compounder and Franchise Businesses
Many high-quality businesses, above all Compounders and Franchises, trade at persistent premium multiples that reflect their profitability, durability, and growth. Those premiums become a risk when rates climb or growth assumptions are challenged, as even excellent businesses can suffer meaningful multiple compression.
Chart 19 illustrates the dynamic. As the weighted-average 10-year government bond yield across major EAFE regions fell from 2011 to its 2020 trough, the Compounder valuation premium (the spread in trailing twelve-month price-to-earnings between the top Compounder quintile and the broader market) expanded steadily, from near zero in 2011 to a peak in March 2021. When rates rose in 2021, Compounders sold off and their premium compressed through 2022. Valuations stabilized in 2023 and 2024 as rates held elevated but steady, though they stayed well below peak.
Since mid-2025, Compounder valuations have recovered modestly, but the rebound has concentrated in AI-related names, particularly semiconductors; many traditional compounder sectors, including Health Care and Consumer Discretionary, remain deeply de-rated. Franchises followed a similar path, premiums expanding through the long decline in rates and contracting sharply during the hiking cycle.
True Quality vs. Cyclical Quality
A second challenge is distinguishing durable competitive advantages from apparent quality that rests on favorable industry conditions or cyclical tailwinds. Companies enjoying temporarily elevated margins, strong commodity prices, or unusually supportive demand can look highly profitable, only to see earnings, margins, and ROIC deteriorate as conditions normalize.
To illustrate, we built a portfolio ranked in the top quintile for operating margins but the bottom decile for five-year earnings stability: profitable businesses that lacked earnings consistency. As Chart 20 shows, this cyclical-quality portfolio produced the weakest long-term performance in the study. High point-in-time profitability, on its own, is not a reliable measure of quality; it often reflects cyclical conditions rather than enduring competitive strength.
Actionable Insights
- Treat quality as multi-dimensional
Given the diversity in underlying return drivers, allocators should avoid treating quality as a single factor. The definitions differ in sector and regional exposure, macroeconomic sensitivity, and performance. Combining several approaches can deliver more balanced exposure and reduce reliance on any one source of return.
- Evaluate quality across full market cycles
Quality has historically delivered attractive long-term returns, especially during periods of economic stress. But individual styles vary widely across environments, and timing them on short-term performance is difficult and often counterproductive.
- Maintain valuation discipline
Compounder and Franchise businesses often merit premium valuations, but those premiums become a real risk when rates rise or growth expectations fall. High-quality businesses can remain excellent long-term investments, yet overpaying for them can materially reduce future returns and raise vulnerability to changing conditions.
- Manager selection matters
Because quality is defined and implemented so differently across managers, knowing each manager’s interpretation, and how it behaves across environments, is essential to portfolio construction. Most managers blend several dimensions, for example a core of Compounders alongside opportunistic Improving Quality positions, or a mix of all four. For multi-manager investors especially, mapping these underlying exposures is what lets allocators build diversified, robust portfolios capable of navigating a wide range of market environments.
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This report is based on information believed to be correct but is subject to revision. Although the information provided herein has been obtained from sources which Xponance® believes to be reliable, Xponance® does not guarantee its accuracy, and such information may be incomplete or condensed. Additional information is available from Xponance® upon request. All performance and other projections are historical and do not guarantee future performance. No assurance can be given that any particular investment objective or strategy will be achieved at a given time and actual investment results may vary over any given time.