2012 Issue 3
Strategies attract investor interest by offering the potential for downside protection and better performance over market cycles.
In today’s unpredictable markets, institutional investors are paying greater attention to the concept of quality in their investment strategies. The reason is straightforward — research shows portfolios with a core holding of high-quality companies tend to outperform their benchmarks and offer some downside protection over a full market cycle.
The popularity of quality-focused investment strategies tends to ebb and flow with stock market conditions, so it is no surprise that they are currently getting more attention. Economic uncertainty and the eurozone crisis have made investors skittish, causing them to re-evaluate their portfolios and to seek out high-quality companies that can better weather all storms. However, while many investment strategies may use the same “quality” label, investors are advised to look carefully at the methodology, underlying holdings, and consistency of returns when reviewing the various offerings in the marketplace.
“There are different definitions and nuances of quality that have evolved over time,” said Matt Peron, head of active equity at Northern Trust. “We believe a quality-focused strategy should not just look at the historical metrics but, at the highest conceptual level, focus on how companies can demonstrate sustainability and durability in the future.”
Quality investing is not a new concept, but investors are increasingly turning to these strategies because they offer downside protection and more consistent returns — significant factors in the current turbulent market conditions. Equally as important, high-quality stocks have outperformed large- and small-cap growth and value stocks with substantially less volatility over a full market cycle. A large body of empirical evidence and numerous academic studies underscore these characteristics of high-quality stocks.
“We believe a quality-focused strategy should not just look at the historical metrics but, at the highest conceptual level, focus on how companies can demonstrate sustainability and durability in the future.”
— Matt Peron, head of active equity, Northern Trust
For example, Northern Trust research shows an unconstrained portfolio of high-quality stocks generated an annualized return of 17.7% during the 22-year period between 1979 and 2011, compared with an annualized 11.3% return for the broader Russell 3000 index during the same period. Another study1 revealed that between 1968 and 2008, stocks in the lowest quintile of volatility outperformed the market on a risk-adjusted basis by 2% a year — essentially duplicating the market’s return — but with 33% less volatility.
These results run contrary to the long-held view embedded in the Capital Asset Pricing Model (CAPM), which suggests that to achieve greater returns, investors need to take on additional risk. When taking on additional risk, investors may adopt any number of flawed approaches. For example, the so-called lottery effect, whereby investors are willing to assume more risk if the potential payoff — however unlikely to occur — is sufficiently large enough. There also exists irrational support for high-risk stocks from a “representativeness” bias, which is the tendency for investors to jump to simplistic, and often incorrect, conclusions from just a few observations. Finally, when it comes to high-growth stocks, there may also exist a greater sense of overconfidence among investors. That is, when valuing stocks, investors veer toward optimism and stick with the false precision of their estimates.
High-quality stocks have outperformed large- and small-cap growth and value stocks with substantially less volatility over a full market cycle.
Despite the results, quality isn’t always top-of-mind among investors. Yet, since portfolios focused on quality investments can potentially achieve superior performance compared with CAPM portfolios, a quality-focused approach is certainly worth a closer look.
“Companies that typically fit into a quality portfolio are stable firms that produce consistent results in all market conditions,” said Scott Ayres, senior product manager at Northern Trust. “Investors are typically drawn to growth stocks that promise 10 times return, not the consistent performers. As studies and empirical results have shown, however, consistency can produce outperformance.”
Although “quality” is among the most overused terms in the investment vernacular, there are some quantifiable measures common to most quality approaches, such as analyzing a company’s earnings patterns, cash flow, debt level and income stream. In addition, many strategies assess a company’s management team by examining capital expenditures and asset turnover rates.
“Investors are typically drawn to growth stocks that promise 10 times return, not the consistent performers. As studies and empirical results have shown, however, consistency can produce outperformance.”
— Scott Ayres, senior product manager, Northern Trust
Some approaches put more emphasis on the strength of the management team, while others look more closely at financial performance. Often, however, they go hand in hand. For example, a prudent management team that uses capital judiciously often sets the stage for operational efficiency and a sharper competitive edge, increasing the potential for strong growth in earnings, cash flows, share buybacks and dividend increases. These companies also are better positioned to deliver positive incremental returns than companies with more aggressive management teams that may be overleveraged or rely heavily on external financing. This debt overhang tends to limit their flexibility and can lock them into an expensive capital expenditure program that they cannot exit when markets turn volatile. In contrast, cash-rich companies can easily meet their debt obligations and day-today liquidity requirements.
As with any investment strategy, high-quality investing does have occasional periods of underperformance, such as in 2009 when lower quality stocks rebounded sharply after hitting a nadir in 2008. Northern Trust analysis shows that during this period the lowest return on equity (ROE) quintile of the market generated returns of more than 67%, compared with about 42% for the top ROE quintile.
High-quality stocks can also become expensive as more investors crowd in, but as Ayres noted “we believe they warrant the premium because of their long-term performance.” In other words, they tend to outperform in relative terms during times of market panic, while still producing strong absolute returns when times are good.
Because of the different approaches to quality investing in the market, it is vital for investors to do their homework and look beyond the branding at the underlying holdings and methodology. Fund managers with a long track record, experience and distinct philosophy are well placed to help investors navigate the quality path.
“We believe an effective core quality philosophy emphasizes a multifactor approach and consistency of results, as well as a careful assessment of the management efficiency and profitability of each company, relative to its peers,” Peron said. “Such an evaluation should be done on a regional and sector basis, which is important because it enables the investor to control risk and to produce a well-diversified portfolio.”
When employing a quality-focused approach, it is important to include additional factors to the core philosophy, depending on capitalization and portfolio objectives.
In addition, Ayres noted, some fund managers look at risk management as an overlay and then adjust allocations accordingly. “But we believe risk management is an inherent part of the stock selection process,” he said. “Such a process, which starts early, minimizes the uncompensated risks and adds to the incremental consistency of results.”
When employing a quality-focused approach, we believe it is important to include additional factors to your core philosophy, depending on capitalization and portfolio objectives. For example, a quantitative large-cap strategy may include sentiment factors such as analyst revision ratios and earnings momentum, while strategies focused on dividend yield can contain an assessment of cash when evaluating a company’s attractiveness relative to its peer group. “There is more than one way to approach quality,” Peron said. “We know how to tailor the models to individual market segments.”
Investing in quality stocks is not a static process. The research needs to be ongoing with experienced quantitative and fundamental teams adapting to changing market conditions and available data in order to construct quality portfolios that outperform in all market conditions.
1 “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly” Malcolm Baker, Brendan Bradley and Jeffrey Wurgler Financial Analysts Journal, January/February 2011
Northern Trust’s proprietary multi-factor models, used across active equity solutions to identify and invest in quality companies, include an assessment of the management and profitability of each company relative to its peers. Using an empirically tested approach that identifies quality companies within each sector, this method seeks to create investor portfolios better positioned to deliver outperformance with controlled volatility.
Additional factors based on — and tailored to — each investment product enter into the core quality philosophy. Effective methods to implement quality may differ based on various factors, such as capitalization range and portfolio objective.
For example, Northern Trust strategies focused on dividend yield also include an assessment of cash factors when evaluating a company’s strength relative to its peers. Quantitative large-cap strategies also incorporate sentiment factors such as analyst revision ratios and earnings momentum when assessing a company’s attractiveness.
In certain small-cap strategies, a core quality philosophy is used in an exclusionary fashion. For instance, Northern Trust has found measurable benefit to identifying and limiting exposure to companies with lower quality — companies believed to have signs of distress and, typically, future underperformance.
While nuances exist regarding the exact proprietary metric of quality used within each product and market segment, consistency lies in using a multi-factor approach to actively seek quality companies in a risk-controlled manner.