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“Short-termism can lead to insufficient investment in the sources of a company’s competitive advantage, as well as capital allocation decisions that are misaligned with the long-term needs of investors”
Source: Clyde Rossouw, Simon Brazier – co-heads of Quality at Investec Asset Management – and Neil Finlay, Quality product specialist, highlight how Quality investing is well suited to long-horizon investment.
What do we mean by “Quality”?
Quality companies have hard-to-replicate, enduring competitive advantages, typically derived from intangible assets, such as brands, patents, copyrights, licenses and distribution networks. These competitive advantages create barriers to entry that allow such companies to sustain high levels of profitability. Quality companies often have dominant market positions, operating in stable, growing industries, with low sensitivity to the economic and market cycle. They are capital light, financially strong and highly cash generative, making them ideally suited to long-term investing.
Long-horizon return opportunities
Our studies show that in general over rolling five-year periods between 1988 and 20161 companies in the consumer staples, healthcare and information technology sectors not only started with the highest levels of profitability (as measured by Return On Invested Capital (ROIC)), but also did better at sustaining those profits over time (Figure 1). These sectors are typically where Quality companies are most prevalent.
Figure 1: Significant divergence in ROIC decay profiles by sector for companies with Q1 ROIC
Source: Investec Asset Management, FactSet, 1988-2016
Our studies also show that investing in Quality companies that are able to sustain top-quartile ROIC tends to enhance long-term shareholder returns (Figure 2).
Figure 2: Investing in companies with Q1 ROIC is most likely to provide strong returns after five years
Source: Investec Asset Management analysis of Factset and MSCI data.
Note: Quarters are cumulative as at 31.12.16.
As a company’s ROIC is partly a function of its margin profile, the sustainability of a company’s margin is also important. Here again, our studies of rolling 5-year periods show that Quality sectors have demonstrated far greater operating profit margin resilience (Figure 3).
Figure 3: Significant divergence in margin decay profiles by sector for companies with Q1 margins for the period between 1988 and 2016
Source: Investec Asset Management, FactSet, 1988-2016
Significant research and development (R&D) investment has been key to the sustainable growth, ROIC and margin of Quality sectors. R&D investment helps drive product innovation and improves brand awareness and loyalty. Given their consistent cash generation, capital-light Quality sectors have typically been able to invest more heavily in R&D as a percentage of sales (Figure 4), as well as in Advertising and Promotion (A&P) in the case of consumer staples.
Figure 4: R&D investment drives innovation and helps sustain a company’s competitive advantage
Source: Investec Asset Management, FactSet, 31 March 2017
Active ownership and managing stakeholder relationships
As long-term shareholders, Quality investors are ideally placed to engage actively with company management and ensure that capital allocation is fully aligned with the long-term interests of all key stakeholders.
Stakeholders include not just management teams and shareholders, but governments, regulators, society, employees, customers, competitors and suppliers as well. Successful engagement with stakeholders can provide important business and customer intelligence, open new markets, reduce risk, improve supply-chain efficiency, build brand loyalty and reputation, and support creativity and innovation. It can lead to improved employee satisfaction, which itself can lead to enhanced productivity, as well as talent retention and attraction. Having strong stakeholder relationships can itself be a key competitive advantage, therefore, supporting long-term value creation.
Capturing systematic mispricing
Active qualitative research is essential to fully assess the sustainability of a company’s business model, competitive advantage and stakeholder relationships. Headline Quality metrics may not by themselves show, for example, the strength of a company’s competitive positioning and market share, the impact of short-term currency movements, dependency on the economic cycle, relationships with key stakeholders, or business tail risks such as regulatory risk or over-reliance on a Different levels of disclosure, accounting treatments and calculation methodologies, as well as corporate activity leading to one-off gains or losses, all make cross-company comparisons difficult using solely a passive or quantitative-based approach.
Alongside proprietary bottom-up research, an understanding of valuation is important, as how much the market is willing to pay for a company’s earnings and cashflows is a key determinant of long-term performance, not just the earnings and cashflows themselves. Although commonly used by investors, we believe that the price earnings (PE) ratio is a blunt tool that unfairly penalises unlevered businesses, especially in an environment where debt servicing costs are low. Furthermore, no account is made of the quality of the earnings, and whether they represent a high or a low return on the capital invested in the business.
We believe there are other measures, such as enterprise value to operating profit and free cashflow (FCF) yield that better reflect the capital structure and cash-generating power of a business and, therefore, better determine whether a stock is expensive or cheap.
Figure 5 shows that, while Quality sectors have outperformed over the past 10 years, this performance has not come from a re-rating; FCF yields are still in line with history. Additionally, these sectors continue to exhibit ROIC significantly in excess of the wider market. When put into context, therefore, we believe that Quality stocks continue to offer good value.
Figure 5: Relative valuations remain attractive for Quality stocks
Source: Investec Asset Management, as at 31/05/2017
Cost reduction and loss mitigation – minimising transaction costs and avoiding permanent capital loss
Finally, as well as achieving gains, also important to long-term returns is avoiding losses and unnecessary transaction costs. Tangible costs associated with trading are unavoidable but tend to be lower for long-term investors. Also harmful to performance can be the opportunity cost incurred by futile attempts to time the market or chase short-term performance. With regard to risk management, we believe downside protection and avoiding permanent capital loss is more important than tracking error. Managing business, financial, capital allocation and valuation risk is essential to benefit fully from the long-term power of compounding.
Bringing it all together
An active Quality approach, driven by in-depth proprietary fundamental analysis, and implemented through a high-conviction, focused, low-turnover portfolio, is well placed to capture the benefits of long-term investing, and deliver strong performance with below average levels of risk.
Clyde Rossouw, Simon Brazier - co-heads of Quality and Neil Finlay - Quality product specialist at Investec Asset Management, define the unique characteristics of Quality as an asset class and highlight how it is well suited to long-horizon investment. Read our latest thought paper:
‘Long-term investing – an active Quality equity approach’.
- Please refer to our 2016 paper ‘Equity Investing the Quality way’ for the full methodology.