Why it can be worth paying a premium for quality shares

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From the day we start investing in the sharemarket we are told that the aim of the game is to “buy low and sell high”. So all you need to do is identify value, and avoid expensive stocks. Simple!

Some fund managers spend their entire working lives trying to live by this mantra of value investing in search of the outperformance they need to charge ahead in the league tables.

However, there is an old saying in the sharemarket. “If it sounds too good to be true, it probably is”. This is a lesson value investors have learnt the hard way when they purchase stocks that are rated as “buy” due to a price/value discount, only to find out that the stocks become a “stronger buy” as prices fall further.

This disappointment is compounded when they avoided companies that were a little expensive only to find that those stocks became increasingly expensive as prices rose.

Value investing is not the only option investors have to achieve capital appreciation over the long term. Investors can also choose to employ a “quality growth” strategy.

In this style of investing, what tends to be more important is the company’s operational performance and its fundamental metrics, such as profitability and financial strength. The idea is that should a company retain its quality characteristics, the share price will look after itself in the long run.

Price point

This may mean an investor will pay a premium for the quality business of today and tomorrow, irrespective of the current price.

It should be noted that this method of ignoring price is not without its risks – particularly if the price simply becomes too hot prior to the release of an underwhelming set of results. More often than not, this can result in the share price correcting heavily, thus eroding a significant amount of previously generated gains.

Both methods of value and quality investing have their strengths and weaknesses. Both have their periods of out- and under-performance depending on which market cycle we are in. But over the long run, which is the better method to employ and what has history taught us from a global perspective?

To answer this question, we need to study history starting at an historic date of market significance in order to capture sufficient cycle behaviour.

For this exercise we lean on data from recognised US research provider MSCI Incorporated, which produces a number of factor-based indices derived from companies in more than 23 countries. Within this suite of factor indices, there are two non-subjective quantitative processes that we will use. One is the MSCI Quality Index which the company refers to as “stocks with high-quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.” The other is the MSCI Value Index which ranks stocks on “book value to price, 12-month forward earnings to price and dividend yield”.

To simplify, the quality index focuses on businesses that rank higher from an operational perspective whereas the latter focuses on ranking the stocks based on their relative value.

Quality up trumps

The results? Using the eve of the onset of the GFC-induced market correction in October 2007 (10 years ago) as our starting point, we find a compelling set of results.

From October 31, 2007 to October 31, 2017, the MSCI Value Index returned 3.7 per cent a year, whereas the MSCI Quality Index gained 7.7 per cent per annum. This means that a naïve quality-based investment strategy outperformed a similarly naïve value-based strategy, every year over the past 10 years.

Statistics like these validate our belief that the best way to achieve long-term outperformance in the market is by adopting a quality focused strategy.

Of course, as with any statistical-based study, there will be periods of underperformance, including last year where the cycle turned against quality investing and toward deep-value stories. Nor is there any guarantee that the trend of the past 10 years will continue.

However, the staff at Lincoln Indicators argue that history doesn’t happen by accident, and that an investing strategy based on identifying the quality future leaders of today is a far more profitable long-term strategy than a hit-and-hope value-based approach.


Published Tuesday, 21 November 2017
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