Quality. What is it? How do fund buyers assess the changing quality of fund manager portfolios and can quality really be accessible at a reasonable price? Can quality arise in value and growth tilted portfolios and at any size? Does quality change through the cycle or only its price? How does a fund buyer separate quality from bond proxies? What then to make of the new Quality factor ETFs? Is quality still a solid basis for buying global equity funds?
“Quality factor is a concept that is applicable in many areas of physics and engineering. It is denoted by the letter Q and may be referred to as the Q factor. In physics the concept of Q, Quality Factor was first envisaged by an engineer named K. S. Johnson from the Engineering Department of the Western Electric Company in the US.” Wikipedia.
Whilst global equity investing and Johnson’s study in resistance of coils are quite different; the concept of quality and resilience is portable. The new QARP (Quality At Reasonable Price) ETF, by DWS, for example tracks the Russell 1000 2Qual/Val 5% Capped Index. That benchmark “aims to identify companies that have strong quality scores relative to peers, while also looking at the value scores of the securities to avoid those quality companies that are potentially overpriced,” according to DWS. The index comprises 385 stocks, about 26% in Tech names, industrial and healthcare making up about a third of the fund, consumer stocks about a quarter. Key holdings include Apple, Boeing Co, Johnson & Johnson, Intel Corp, Wal-Mart. We will explore the index methodology later.
I’m sure many of us have watched the Zuckerberg senate and congress committees; not to mention the resulting volatility in Tech stocks and markets generally as Syria overtakes Siri. This was particularly embarrassing for one UK minister when his IPhone mistook a Syrian military debate as a voice prompted question during a well known BBC TV debate show. It has brought into sharp relief the quality of Facebook’s earnings stream. How Fund managers determine quality is far from agreed. Glibly put, when quality is king then both value and growth managers argue for holding quality; when it’s down then everyone is contrarian. Style agnostic managers are less wedded but will exploit quality stocks if and when they can see a valuation anomaly.
Thus the rise of bond proxy stocks from unloved ‘zombies’ to darling ‘quality’ is an interesting observation of investor behaviour, until 2015 most of these companies were classified as value and out of love. Fallen angels, defensives, laggards, compounders, value traps even. Then as the maturing bull market sought room to grow; led by a vanguard of Tech stocks, these stocks with their lower rating, but higher cash flow than market, became more popular. Boring became sexy like Utilities and Consumer Staples. The stocks were re-rated, priced-up, value investors exited, growth investors moved in, they gathered momentum then (as inflation and monetary policy began to turn) they fell back. Having moved in favour of growth managers over value in the last 10 years; fund buyers were left reeling by the reversal and fund managers with valuation discipline started putting plenty of distance between themselves and those once steady compounders.
Stylistically in SmartBETA land, Quality At a Reasonable Price (‘QARP’) is the new vogue. Is it a new singularity, can resilience perform through an entire economic cycle? As the voice of value managers finally begins to rise after a long hiatus; the strength of the ‘quality’ premium has begun to show strong signs of heading South. The dissent for bond proxies began to emerge in 2017 and into 2018 fund buyers, again, are reassessing the case for style rotation and trying to determine which group of global equity managers has it right this time. Who is right?
First we need to sharpen our pencils when it comes to assessing what is quality. The notion of quality and what makes a quality stock has been heatedly debated over recent years. The inflection in monetary easing and rates has again reignited the efficacy of bond proxy stocks, which had become the fashionable perennials of income-producing, safe-haven investing franchises. A “bond proxy” was shorthand to describe equities such as consumer staples and utilities with safe, predictable returns, but have higher yields than much of the bond market (and, crucially, yields which can grow over time). Example Bond proxy companies familiar to many include Unilever, AB InBev, Procter & Gamble, Bunzl, Nestle, Reckitt, Mondolez. In many ways they are the antithesis of Technology stocks like Amazon, Netflix or Alphabet. A quality (or ‘blue chip’) company on the other hand may include a broader universe of companies considered to have strong brand presence or ‘franchise’: e.g. Apple, Disney. In 2015 James Bjorkman for SeekingAlpha covered the Forbes top brand list;
• General Electric
• Louis Vuitton
• American Express
From that list, arguably, the only bond proxies might be considered to be Coca Cola, McDonald’s, Walmart and Budweiser. To be deemed a quality company requires brand and market strength, profitability and a view that the strength can last. “A quality company that has a top brand becomes a good stock (assuming it even trades publicly, many top brands are privately held) only after the market decides that the company's success is assured and it will durably maintain its niche for the foreseeable future.”
Where confusion between bond proxies and quality arises is across a number of common factors: such as high cash flow, low leverage (debt) and positive return on capital/assets. This is where it gets tricky for the fund buyer. Where the difference tends to arise is the rating of the stock, it’s expected future growth. Here the rating on a bond proxy will likely be lower than a growing quality name or a quality company trading unnecessarily at discount to intrinsic value. That difference unfolds over the long-term, bond proxies tend to have mature business models and lower outright growth and internal rate of returns. You get next to no re-rating on a bond proxy as the earnings stream is already priced by the market. In conflating quality and bond proxies together, had the buyer’s view of ‘quality’ become misplaced? Certainly it has become skewed in recent years to focus around large defensives that generate bond like yields through a market cycle. Actually ‘quality’ should itself not refer to price or valuation multiple. Hence, as the valuation multiple changes through the business cycle, then quality companies can find themselves attractive to either value or growth managers.
The perception of quality in turn becomes hotly contested between both camps, each taking turns to sequentially own and renounce quality stocks. Of course in many cases the common denominator may well be the same, the companies held. What tends to change is the nominator, price. To illustrate, let’s look at what various global equity managers have said about quality stocks in recent years.
Terry Smith in 2015 wrote for the FT;
“If you are a long-term investor you should own the high-quality bond proxies and close your ears to the siren song of those who say a rate rise will cause you problems. It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” Warren Buffett once said. I agree with Mr Buffett’s description of a good company. To quote from his 1979 annual chairman’s letter: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share. If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at. That’s why if you are a long-term investor you should own the high-quality bond proxies and close your ears to the siren song of those who say a rate rise will cause you problems. If you are not a long-term investor, I wonder what you are doing in the stock market at all and so will you one day.
Smith is known for holding onto his ideas, like Buffet. A recent review of Berkshire Hathaway’s positions point to many of those quality names like Pharma stock Sanofi at 4.2% dividend yield, 11-12x P/E, held by Buffet since 2006 as well as value names like Detroit Auto GM at 6-7x P/E and a dividend yield of 3.7%. Then compare this to bond proxy Food giant Kraft Heinz at 18x P/E, 3.7% dividend yield which Buffet sees as a multi-decade holding.
“The short term doesn’t make much difference to us, because we will be in this stock forever. This is a business with us. It’s not really a stock…It’s where the new Kraft Heinz Co. is 10, 20, 50 years from now that counts to Berkshire. These are brands I liked 30-plus years ago, and I like them today. And I think I’ll like them 30 years from now.”
Michael Lindsell has commented more recently, as the firm has come under scrutiny for holding Bond proxies.
“..we are told that our investment approach of concentrating on “quality” and “long-duration” equity assets makes the strategy particularly vulnerable during periods of rising interest rates, rising inflation and accelerating economic growth. In this environment - again we are assured - we should expect “interest rate sensitive” stocks to sell off and for “value” and “cyclicals” to outperform.. it is too simple to say that if interest rates go up all so-called interest rate sensitive shares will fall. While it is true that Diageo and Unilever have fallen in 2018 – by up to 10%, it is also true that other consumer branded goods shares have done rather better. Within your portfolio Mondelez is up 3%, for instance, while Heineken is down by less than 1%. Meanwhile, Laurent Perrier is up 15%.“
Jeremy Podger in interview with Morningstar in July 2017 noted;
‘I think that you do have to have a quality threshold. One thing that I'm trying to avoid is bombed out situations with no apparent catalyst for improvement. So, it's really important, I find that you take a medium to longer term view of margin – profit margin potential in the companies that you are looking at. And for that to drive the valuations higher. So that’s the central category of what I look for, exceptional value.. There's been a huge convergence in sort of safe reliable growth companies But if I look at those today they are firstly expensive and secondly the growth potential in things like staple consumer goods companies is not what it once was. It's looking a little bit pressured. So, again you need to be a bit, a bit selective also not going for the super hyper growth, super highly valued companies and you might end up for example.’
Is quality then cyclical just as we consider value and growth? The conundrum of QARP was recently observed by Dan Kemp, EMEA CIO for Morningstar who noted recently:
“By looking at the world quality index under a rounded definition of quality, we find that these stocks are not immune to investment cyclicality, with quality stocks experiencing valuation changes across the cycle like many other traditional market-cap weighted assets.”
Dan notes that the quality universe of stocks has been dominated by US Tech stocks, which has offered a significant tailwind. US stocks making 70% of the index and Tech making up 36%. Once adjusted Dan notes that the expected return of quality stocks is less appealing.
“we find that quality generally offers low prospective return profile across the board in absolute terms, low single digit returns in real terms, plus it could also be exposed to meaningful drawdowns given the stretched valuations. Nevertheless, quality stocks do appear considerably more attractive than market-cap weighted counterparts on a valuation-implied basis, highlighting possible pockets of opportunity.
Back to my earlier point of investment style, Dan notes valuation opportunities do persist in the US market, Europe, GEM but not Japan. Nonetheless quality stocks remain sensitive to the investment cycle and valuations and he’s right of course.
“In summary, we find that quality stocks are subject to investment cyclicality like many other traditional asset classes, although can offer defensive characteristics and may help diversify against pro-cyclical positions. It is all about how you define it.”
So what underpins QARP? If we look at FTSE Russell’s definition of quality then we can begin to consider how to define and rank ‘quality’ stocks. FTSE Russell pull on significant academic research. It is worth noting that like most measures, quality is relative and therefore the average ebbs and flows, grows and contracts through the market cycle;
• “Return on Assets (ROA) and change in Asset Turnover (ATO): We find that historically companies with high current levels of ROA and larger changes in ATO have displayed superior subsequent operating performance. Historically, quality companies identified using these measures have outperformed those with lower levels of ROA and smaller changes in ATO. Highly profitable companies that display improvements in operating efficiency also exhibit lower levels of volatility and systematic risk.
• Accruals: Historically, companies with higher levels of accruals have been associated with lower levels of future profitability and display lower risk adjusted performance outcomes.
• Operating Cash flow to Total Debt (OPCFD): ROA, change in ATO and accruals assess earnings quality from a profitability perspective. Leverage provides another perspective on quality. We find that historically, OPCFD is positively associated with future profitability, i.e. increased levels of leverage are associated with lower levels of future profitability.”
FTSE Russell are supported by Asness et al (2013) who proposed a general definition of quality arising from a re-formulation of the Gordon growth model, where P, D, r and g are; the current stock price, dividend, discount rate and growth rate in dividends respectively.
P= D/r−g = Earnings *Payout Ratio/r−g
“If high quality securities possess common characteristics, then the equation suggests that these attributes may include profitability, growth in earnings, the required return (i.e. safer stocks) and the proportion of earnings returned to the shareholders as dividends (i.e. payout ratio).”
Bender and Nielsen (2013) examined a narrower definition of quality: Earnings quality or accruals. They found strong empirical evidence of a quality effect that persists after controlling for common risk factors such as size, value, momentum and volatility. Hunstad (2013) demonstrated high quality stocks earned a risk premium. He suggested risk-averse investors hold high quality stocks in order to achieve greater certainty in investment outcomes, i.e. high quality stocks should exhibit lower price volatility and risk-seeking investors bid up the price of low quality stocks, resulting in a quality premium.
S&P apply a similar methodology to ascertain stock quality to rank and weight into their index series.
• Return on Equity (ROE). This is calculated as a company’s trailing 12-month earnings per share divided by its latest book value per share (BVPS)
• Accruals Ratio. This is computed using the change of a company’s net operating assets over the last year divided by its average net operating assets over the last two years:
• Financial Leverage Ratio. This is calculated as a company’s latest total debt divided by its book value.
Piotroski F Score: Lastly, one of my favourite rankers for separating quality from value traps is the F score, devised by Joseph D. Piotroski, The University of Chicago in his paper ‘Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” where he noted;
“nearly half of all high book-to-market firms are classified as having high levels of financial distress or poor trends in profitability.” His composite tanker captured many of the measures noted above such as return on assets, cash flow, accruals and leverage but also changes in liquidity and operating margin. Here then quality and intrinsic value crossover in the ‘margin of safety’.
F_ SCORE = F_ ROA + F_ changeROA + F_CFO + F_ ACCRUAL + F_ changeMARGIN
- F_ changeTURN + F_ changeLEVER + F_ changeLIQUID + EQ_OFFER.
How then to capture funds that hold companies with lower leverage, strong balance sheets and cash flow? Traditional style measures offer limited insight; quality is cyclical and can transcend either value or growth investing for reasons explained above. Instead I suggest using macro factors that will pick up a fund’s sensitivity to leverage (term premium, default spreads), volatility, inflation and so on. In a rising growth environment, typified by inflation, bond proxies tend to lag. This addresses the issue of sector rotation, cyclicality, the rise and fall of bond proxies and identifies that funds hold QARP (or not) through companies with lower debt, better cash flow and growing operating margin. In particular inflation sensitivity (positive) is one way to separate bond proxies from quality franchises but only once you have identified that there is less leverage, good return of assets belying. Combining factor analysis with say a F score analysis of a fund’s top 10 are good indicators.
Alas Quality is not a singularity; the price you pay for quality still matters but with valuation discipline, QARP remains a sensible starting point for global equities.