By Matt Quinn, CFA® February 2019
As many of you know, Roger loves sharing books. He recently encouraged the team at Legacy Consulting Group to read the book My One Word by Mike Ashcraft. The concept of the book is simple; find one word that can be your primary focus for one year rather than creating a long list of New Year’s resolutions. From an investment perspective, Steve and I have decided our focus word for 2019 is ‘quality’. The word quality has several meanings and may mean different things to different people. We like to think of quality as something that has an essential characteristic or distinguishing feature, a degree of excellence or superiority in kind, or notable status.
When I think of the term quality, I think of diamonds. After all, perhaps no other industry has spent as much time and effort defining quality as the diamond industry. If you have ever had the pleasure of buying diamonds, they are generally graded based on their four ‘C’ quality characteristics – cut, clarity, color, and carat. While a purchaser may have general preferences as it relates to shape or size depending on how the diamond is going to be set, the real value differential for diamonds comes from the cut and color of the diamond. After all, a diamond that isn’t clear or doesn’t sparkle really isn’t a “girl’s best friend.”
Like diamonds and the definition of quality itself, the quality of a stock or bond may be in the eye of the beholder. In fact, professional investors often differ in terms of which quality characteristics they find to be of greatest value. While growth-oriented equity investors may believe earnings growth and profitability are most important, many bond and value-oriented stock investors focus more on cash flow and balance sheet metrics. Naturally, we think some combination of these approaches makes the most sense from a diversification standpoint. In fact, we allocate to managers that utilize a variety of quality characteristics to manage their investment portfolios. One of our core domestic large cap equity managers takes a more conservative income-oriented approach and looks at quality not only from a business sustainability perspective, but also based on a company’s willingness and ability to pay shareholder’s dividends. From their perspective, the best way to protect on the downside and generate a positive total return for investors in more difficult market environments is through dividends. Two of our more opportunistic, growth-oriented equity managers also use a quality growth framework to evaluate companies.
In terms of the stock portfolios we manage, we group our quality characteristics into four primary categories – profitability (earnings margin, margin expansion, and return on equity), growth (revenue and earnings growth), margin of safety (debt load), and payout (dividend yield, growth, and payout ratio). To be clear, we are not looking for diamonds in the rough. The companies we prefer are already polished, well managed businesses that have reasonable growth outlooks, healthy balance sheets, and generally pay dividends to shareholders. We believe these types of companies should be appreciated by the general market, particularly during times of increased volatility. A fifth element we consider as part of quality is a company’s environmental, social, and governance (ESG) ratings. ESG ratings are designed to help investors evaluate companies based on their commitments to sustainable and ethical business practices. We think well run companies should adhere to good governance standards and be willing to articulate their overall impact on society and the environment. Linking back to the diamond discussion above, no one wants to willingly own “blood” or “conflict” diamonds.
What is an example of a quality company? While we do not presently own shares of Dallas-based Southwest Airlines (LUV) in our stock portfolios, the recent passing of the company’s co-founder Herb Kelleher is a great reminder of how a focus on quality can lead to substantial rewards for patient long-term oriented investors. As Bill Taylor aptly noted in a recent blog for Harvard Business Review, “as large a shadow as Kelleher cast over the airline business, his company won big because of a commitment to simplicity and consistency rather than nonstop innovation.” As Mr. Taylor goes on to explain, the company flew just one kind of plane for decades to simplify fleet operations, avoided the chaos of traditional hub and spoke systems, and refused to fall in line with industry practices that increased revenues but also angered passengers and complicated operations. This focus on giving customers the ‘freedom to fly’ (essential characteristic), generating consistent cash flow in a highly cyclical industry (degree of excellence), and prudently managing its balance sheet (notable status) are core components for the types of quality companies we are seeking.
Given our belief that slower growth and higher volatility will lead to “Ok” returns for both stocks and bonds in 2019, we think emphasizing quality more within our underlying investment decisions makes sense. Based on industry research, high quality stocks tend to hold value better than low quality stocks during times of market stress. Quality also tends to do better than value or momentum-based investment strategies during the latter stages of the business cycle. In terms of fixed income, higher quality bonds are more likely to hold value and provide diversification benefits as general economic and credit conditions deteriorate.
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- Information presented is believed to be current. It should not be viewed as personalized investment advice or as an offer to buy or sell any of the securities discussed. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed.
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