The under-the-radar investment theme Wall Street says can protect you from AI panic

Financial markets have been navigating rocky seas in recent weeks, and a growing number of Wall Street analysts are telling investors to find a port to wait out the storm.

That proverbial port is quality stocks, commonly defined as companies with a long track record of growing earnings, a durable competitive advantage, low debt levels, and proven management teams.

Rising interest rates — thanks to sticky inflation, government borrowing, and huge demand for capital to build out AI infrastructure — have pummeled many stocks tied to the AI trade over the last few weeks, including chip firms and cloud companies.

Investors have bid up their prices to astronomical levels on expected future growth, but now worry that a potential decline in AI spending could lower those expectations.

Quality stocks, meanwhile, tend to have more established businesses and a history of earnings growth, and are therefore less volatile. Given fears around the staying power of the AI buildout trade, Wall Street thinks it’s a great time to have exposure to the quality factor.

Morgan Stanley has been highlighting the factor for weeks in its client notes, and again endorsed the trade on Monday.

It pointed to the spread in earnings revisions breadth between high-quality and low-quality stocks. High-quality stocks are increasingly seeing better earnings growth relative to low-quality stocks.

“The revisions spread has tended to lead relative performance by roughly 6—12 months. When it has been in the top quintile of its historical revisions range, as it is today, high quality has outperformed low quality by an average of ~8%% over the following 12 months,” Mike Wilson, the bank’s top US equity strategist, said in a note.

The bank recently shared a list of stocks to quality stocks to buy, including Visa, Nvidia, ServiceNow, Apple, and more.

Goldman Sachs also touted the factor in a client note on Monday. The bank shared a screen of “defensive stocks with quality attributes” for investors to consider, like CVS, Kroger, Hershey, Tyson Foods, and more.

In an October 16 client note, Piper Sandler said quality stocks were likely on the brink of outperformance. The firm pointed out that the performance of higher-beta stocks have seemingly topped out by historical standards, and those companies are inversely correlated with the returns of quality-factor stocks.

“When beta’s best days are behind us, quality’s best days are ahead,” wrote Michael Kantrowitz, the chief US equity strategist at the firm.

And Manulife John Hancock Investments said in a note on Friday that quality and value stocks are two ways it prefers to diversify portfolios amid “massive concentration risk” from AI stocks.

Turning to quality stocks doesn’t necessarily mean abandoning the AI trade altogether, however.

James Russo, a portfolio manager of the US Strategic Core Equity strategy at AllianceBernstein, told Business Insider last week that he’s “pivoting hard” into quality stocks, and cited two areas within the AI trade that he thinks fit the bill: large hyperscalers and chip stocks with durable competitive advantages.

Examples of exchange-traded funds that offer broad exposure to quality stocks include the iShares MSCI USA Quality Factor ETF (QUAL), the Vanguard US Quality Factor ETF (VFQY), and the Invesco S&P 500 Quality ETF (SPHQ).

The AI Quality Growth ETF (AQGX), meanwhile, provides exposure to quality stocks within the AI trade.