May 8, 2019
What is quality?
“Quality … you know what it is, yet you don’t know what it is. But that’s self-contradictory. But some things are better than others, that is, they have more quality. But when you try to say what the quality is, apart from the things that have it, it all goes poof! There’s nothing to talk about. But if you can’t say what Quality is, how do you know what it is, or how do you know that it even exists? If no one knows what it is, then for all practical purposes it doesn’t exist at all. But for all practical purposes it really does exist.” - Robert Pirsig, Zen and the Art of Motorcycle Maintenance.
Whilst defining quality is no minor philosophical challenge, we are fortunate that the application of the concept of quality to investing is robust to various definitions, be they qualitative assessments of competitive position or earnings quality and sustainability, or alternatively quantitative measures such as returns on capital, margins and organic growth, or even the volatility of these measures. In practical terms, quality is any characteristic of an asset that, all else equal, commands a higher price.
Fairlight believes the best quantitative proxy for business quality is return on invested capital (ROIC), a measure of the return the company earns on each dollar invested in the business, calculated as after-tax operating profit divided by invested capital (working capital plus fixed assets).
Quality beats junk
There is now more than ninety years of data derived from the US market to support the hypothesis that the returns earnt from investing in high quality stocks exceeds those of the general market. This is complemented by similar, albeit not as long-dated, studies in other markets which leads to the conclusion that the phenomenon is both persistent and pervasive (see Figure 1). Importantly, the quality return premium did not disappear following the first publication on the topic by Novy-Marx in 2006, further increasing its legitimacy.
Finding quality businesses
The key to successful quality investing is identifying businesses that can generate high levels of ROIC in the future and patiently waiting to buy them when their market valuation implies that their ROIC will mean revert.
In the classical model of capitalism, any company that is able to produce a high ROIC will have their advantages competed away with ROIC regressing back towards the mean. In practice however, we find a not insignificant number of companies that are capable of sustaining high ROICs for an extended period of time for a variety of reasons such as innovation, brand, regulatory advantages, network effects and cost advantages.
McKinsey measured the sustainability of company ROICs by categorising the market into quintiles based on historic ROIC, and then tracking the median ROIC for each portfolio over the following fifteen years. The result (shown in Figure 2) demonstrates that while there is certainly some evidence of mean reversion, the companies with historically high performing ROICs did continue to generate higher returns than the rest of the market, even fifteen years later. Put another way, historic profitability is a reasonable predictor of future profitability and time spent researching historically successful companies isn’t time wasted.
Why does quality investing work?
The classical behavioural explanation given for the outperformance of quality stocks is the investor preference for large returns over modest ones, which leads investors to overpay for “lottery tickets” capable of generating large returns while undervaluing the opportunity to compound at more modest rates but importantly with more certainty. This dynamic can also be seen in the historic outperformance of low-risk stocks (as defined by volatility) over their high-risk counterparts in almost all markets studied (Baker and Haugen 2012).
Whilst a valuation insensitive approach has historically worked surprisingly fine, Fairlight believes that given the increasing appreciation of the merits of quality investing since the GFC (as evidenced in the stretched valuations currently ascribed to many high-quality businesses), discipline around valuation is particularly important today. While classical value investing has had a rough decade, buying companies for less than they are worth will never go out of style.