Is quality investing for you?

Warren Buffett has said that the key to investing successfully is being a student of business. When you are investing in stocks, you are investing in companies. Take yourself out of your brokerage account and imagine you are purchasing a company. What would you look for?

I would be looking for a company with strong financials. I would also be looking for a company with stable and consistent earnings, and competent stewardship that will allocate profits efficiently. I would be looking for a strong company that is able to invest capital diligently and generate high returns.

That sounds a lot like a quality investment.

Quality investing is a fundamental investment strategy that looks for characteristics that denote high quality companies. These can be both qualitative assessments where a human assesses and decides that a company is high quality and quantitative factors based on metrics like low levels of debt.

Why would you want to invest in quality companies?

Downside protection is a significant benefit of quality companies. High quality companies are less likely to go out of business. This lowers the risk of an investor’s worst-case scenario of a business shutting down and losing your money.

Theoretically, this means that you are going to get less volatility. In times when the market gets nervous about risk and those riskier, low-quality companies fall, the quality companies fall less.

This isn’t without consequence – there is a trade-off for less volatility. Quality companies fall less during downturns, but they also tend to rise less during euphoric times. These are periods when investors clamour for and seek out more risk, inflating stocks that don’t usually fall in the ‘quality’ basket.

The other positive aspects of quality companies tend to play out over the long-term. These advantages include better management and competitive advantages against their rivals. The combination of lower volatility and longer time horizons means that a quality investing strategy is a long-term strategy. That may not get headlines or generate investor excitement, but it can pay off over the long-term.

What makes a quality stock?

The definition of quality is open to interpretation. It may not be uniform across sector, industry and geography. For professional investors the approach can differ between product providers. These characteristics can be qualitative or quantitative.

A good example of a qualitative assessment is Morningstar’s Moat rating. A company with an economic moat can fend of competition and earn high returns on capital. VanEck’s MOAT ETF MOAT uses the Morningstar moat rating as a basis for inclusion.

There are also quantitative assessments of quality. SPDR MSCI World Quality Mix ETF QMIX combines quality, value and low volatility measures to select holdings. Quality measures include return on equity, debt/equity ratios and earnings variability. VanEck’s Quality ETF QUAL looks for companies with attractive returns on equity, stable earnings growth and low financial leverage. We can take a deeper look at the factors sought by QUAL, which has a Silver Morningstar medalist rating, as an example.

Return on equity

Return on equity is a measure that is calculated by dividing net income by shareholders equity or book value. It is intended to show how efficiently a company generates profits. The higher the return on equity, the better the company is at generating profits from assets.

Debt

Companies that have low debt exhibit characteristics of quality when combined with stable earnings growth and high return on equity. Too much debt is one of the primary reasons companies get in trouble.

Stable earnings growth

Looking for companies that have steady and consistent growth in earnings eliminates companies that are extremely cyclical. These are companies where their earnings depend upon the economic cycle and eliminates industries like commodities. What this has meant in the recently is that quality companies have tended to skew towards large cap technology companies. This has inverted the theory that quality companies are less volatile and have downside protection.

This has little to do with the ‘quality’ aspect of the companies. The largest holdings of QUAL are a good example of this.



The above data from QUAL shows that this has not been the case over the last three years.

The investment has had larger drawdowns than the market, it has been more volatile (indicated by beta) and has captured more downside.

So why has this quality-focused investment been volatile comparative to the market?
The simple answer is that technology occupies overweight positions in indexes. We’ve seen passive investments have overtaken active investments in the US. In an acknowledgement that technology shares drive returns many active managers have also included these large tech giants into their funds.

Volatility in markets has meant that drawdowns and nervousness from investors impacted technology disproportionately. It is hard for the overall market to fall if the largest companies are rising in value.

Considerations for investors

Due to the inclusion of many technology companies, the yields on quality focused managed investments are lower. If you are investing through managed investment products like managed funds or ETFs, income investors may not be able to find a product with strong or consistent yields.

This can be managed by investing directly in quality companies.

It’s important as an investor that you consider your temperament, whether a longer-term investment fits in with your investment strategy and your assessment of your competitive advantages as an investor.

Inexpensive quality stocks

As mentioned, there are qualitative and quantitative ways to find quality stocks. Morningstar Investor currently has 115 stocks that have Narrow and Wide moats in Australia and New Zealand. A narrow moat indicates that a company can protect and grow earnings over at least the next 10 years. A wide moat is 20 years.

There is currently one five-star stock with a wide moat in our coverage - PEXA Group PXA. PEXA operates a virtual monopoly on digital property settlement and lodgement in Australia, at around 99% market share of digital transactions and close to 90% market share of total transactions.

You are able to read more about PEXA and three other cheap wide moat ASX stocks here.

Quality ETFs

The examples in this article are from VanEck’s MSCI Quality ETF QUAL which has a Silver medalist rating – our second highest rating. Our analysts say the ETF is “For investors seeking exposure to high-quality global equities at a low fee, VanEck MSCI International Quality ETF QUAL is a strong choice. We continue to have high conviction on the strategy’s ability to deliver outperformance over the peer group median and serve investors well over the long term.”

My colleague Mark LaMonica has written on three top ETFs that focus on quality shares. It goes deeper into our analyst opinion of QUAL, as well as two other ETFs in our coverage.