Julian Fosh

Reports of Quality’s death are greatly exaggerated

Julian Fosh

Julian Fosh: Reports of Quality’s death are greatly exaggerated

Over the last year or so, there has been a growing investment debate over the prospects for ‘quality’ and ‘value’ investment styles. The concern for some is that shares in high-quality companies have performed very well, and could be vulnerable to a correction relative to ‘value’ stocks. However, to paraphrase Twain, reports of quality’s death are greatly exaggerated; despite a ‘post-Trump wobble’ last year quality actually outperformed value, and this has continued into the current year. In the UK, the latest data suggests that in the three months to 31 May 2017, quality style factors performed strongly in the UK – the best quality quintile outperforming the worst quintile by over 5% while value underperformed with a quintile differential of 4%*.

Here, I take a look at the quality credentials of the Economic Advantage process and explain why we stick with this high-quality style even when others are predicting its demise at the hands of value.

In the Economic Advantage team we are bottom-up stock pickers, but our style does undeniably have certain quality style hallmarks. This is a by-product of the investment process we employ rather than a goal in itself. It is therefore fairly inevitable that we are asked for our view on the quality versus value debate. This discussion essentially revolves around the concept of whether an investment is ‘cheap’ or ‘expensive’ and how one goes about making such a subjective judgement.

To state our positions at the outset, we are big believers in the attractions of quality characteristics. Warren Buffet summed up the choice facing investors very succinctly: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

In other words, it is better to buy a company with quality characteristics – such as good cash flow returns on their capital invested in the business – than one that looks attractive on a simple valuation metric such as the price/earnings (p/e) ratio.

Although precise definitions of quality vary from investor to investor, they all include the notion of companies that earn high returns – usually, high returns on capital or equity – as well as possessing strong balance sheets or solvency. In assessing the Economic Advantage funds’ quality bias, we adopt the definitions used by Canaccord Genuity Quest. Quest identifies three separate style factors – Value, Quality and Momentum. Each of these is in turn comprised of five separate sub-factors.

We favour Quest’s definition of quality because one of its five sub-factors is CFROC spread: the difference between cash flow return on capital and weighted-average cost of capital. This pivotal concept – which asserts that the basic objective of any company is to consistently generate returns on capital in excess of its cost of capital after tax and inflation – forms the second stage of our investment process. The first stage is to assess whether a company’s intangible assets give it a theoretical competitive advantage:  the second stage is, using CFROC spread analysis, to determine whether in practice it is converting that theoretical advantage into a demonstrable actual observed competitive advantage. Superior economic returns provide prima facie evidence of this.

One problem with value investing is that the most widely used method of valuation, the p/e ratio, depends heavily on the ‘e’ – the earnings. And with value stocks particularly, you can’t really be sure about the earnings. Objectively, companies on low p/e ratios (according to forecast earnings) may look pretty ‘cheap,’ but in two or three years’ time, if those earnings are not in fact delivered, then it will become apparent that they were not as cheap as they looked after all. With high-quality stocks, the probability of receiving the given level of earnings – their ‘earnings quality’ – is generally much higher.

For this reason, in-depth examination of valuation metrics such as p/e is less important to us than the identification of the key characteristics that our Economic Advantage investment process is built around. We believe that some companies possess intangible assets which act as barriers to competition. This should allow them to sustain earnings growth, which will serve to erode ‘expensiveness’ and generate good long-term share price returns. Furthermore, because we look for companies whose barriers to competition can allow strong earnings to be sustained for longer than is expected, actual earnings often transpire to be higher than the forecasts used in p/e ratios. This means a company’s shares may be less expensive than a p/e ratio suggests.

We are on the hunt for great companies, and great companies often look expensive. But because analysts and investors sometimes underestimate the durability of these companies’ earnings, they often (ex-post) prove to be less expensive than they had looked (ex-ante). The power of profit compounding erodes this apparent expensiveness.

Looking at valuations is the third stage of the process. Its subordination to the establishment of theoretical Economic Advantage and practical financial advantage is no accident. For our FTSE 350 companies, we do not buy a new company unless it is undervalued on at least one of five measures, though for smaller companies we think of valuation more as a ‘sense check’ before it can be added to the funds.

The five valuation measures we look at are enterprise value/earnings before interest, tax, depreciation and amortisation (EV/EBITDA), EV/sales, dividend yield, free cash flow yield and p/e. The rationale for using a variety of measures is that – as explained above – p/e is a one dimensional measure (overly dependent on ‘earnings’) which does not necessarily capture the true long term earnings power of a company. By using a range of longer-term measures we are appraising the company in greater depth and gaining a much better understanding of its true make-up.

In the same way that we do not pay too much heed to limited valuation measures such as p/e, we try to avoid becoming bogged down in investment labels such as cyclical, defensive, growth etc. These labels matter little to us if we have high conviction that a company has Economic Advantage quality characteristics. To our minds the fact that a business is cyclical or mature (i.e. lower growth) has little influence on whether that company is considered of ‘high-quality’. The best way to understand the investment profile of a portfolio of companies isn’t to segment them into conventional sector, cyclicality or beta buckets, but to get an in-depth understanding of each individual company, particularly through studying its CFROC profile over as many years as is possible. It is through this process of getting to know each company that we are able to risk score each one, and adjust our position weightings accordingly.

Given the current macroeconomic state of play, we think that the quality credentials of the Economic Advantage process are likely to be as valuable as ever. While we make no attempt to forecast the macroeconomic outlook, we are attentive to the current macro landscape via day-to-day company news flow. There are two key themes currently feeding through: (i) imported inflation – sterling weakness is leading to a bout of higher inflation, with the May Consumer Price Index hitting +2.9% inflation year-on-year, which means cost pressures for companies; (ii) consumer and business uncertainty is being exacerbated by political instability as the UK enters Brexit negotiations.

We think that high-quality companies in possession of Economic Advantage have greater control of their own destinies than those which lack such attributes and are at the mercy of such exogenous factors. Ant has already written on the theme of pricing power, and I would add that an uncertain political and macro outlook only strengthens the appeal of good-quality companies with barriers to competition and the ability to sustain earnings.

*Source: Canaccord Genuity QuestTM


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• Some of the Funds managed by the Economic Advantage team invest in smaller companies and companies traded on the Alternative Investment Market.  These stocks may be less liquid and the price swings greater than those in, for example, larger companies. The performance of the Liontrust GF UK Growth Fund may differ from the performance of the Liontrust UK Growth Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

Friday, July 7, 2017, 1:28 PM