Why it's (almost) Quality stocks' time to shine

You know certain parts of the stock market are getting toppy when fund managers drop the “C” word. Comparisons with cryptocurrency emerged twice during the following interviews about Quality stocks and whether their time is nigh. Two out of the three portfolio managers I spoke to mentioned Bitcoin in the same sentence as some of the more speculative corners of the Growth area of the market.

Put simply, Quality is an equity investing style alongside Growth and Value (actually cutting across the others in some ways). Solid balance sheets, high return on equity and good cash flow are among some of the defining Quality characteristics - rather than share price valuation or an outlook for sustained bottom-line growth.

We’ve heard plenty about the “great rotation” from Growth to Value, as the recovery trade grew frothy and investors started stepping into the more cyclical stocks out there – miners and banks in particular. But what about Quality – could this be something of a dark horse investment style for the next few years?

As Fairlight Asset Management’s Ian Carmichael says, “Quality has had a very good decade, but it's had a tough year.”

Growth has outstripped Quality by miles, but it’s also been quite speculative in parts. “Look at all these electric vehicle companies that don't actually have a product; cryptocurrency – you may as well be talking about Pokemon cards,” Carmichael says.

While seeking to define Quality, Jason Teh, CIO and founder of Vertium Asset Management draws on the example of Virgin Australia – a flagship Value stock – as an example where only Bitcoin-like speculation would’ve won out.

And Kelli Meagher, portfolio manager at Sage Capital, provides a three-point explainer on how to identify Quality stocks and why they should be part of your portfolio.

"Quality investing is an anomaly"

Ian Carmichael, portfolio manager, Fairlight Asset Management

All else being equal, companies with high and stable levels of profitability are Quality companies. And companies that have weak and variable levels of profitability, are low-quality companies.

Value is about investors asking, ‘is the market disgusted by this company? And so is there an overreaction? Value is about an emotional overreaction. Growth is for the dreamers. There's less evidence to back up growth in the long run, but it's had a fantastic 10 years.

Quality is about ‘what money do I get back for the money I've put in?’ Let’s say I'm rolling out a McDonald's restaurant in my area. I can see there's capacity there for 10,000 restaurants, but for every restaurant that costs me $1 million to set up, what am I bringing back as profit? The growth investor would say, ‘look at the size of the opportunity,’ while the quality investor says, ‘well, what's the return on that opportunity?'

In terms of why they should be in portfolios, I’m biased, but I think quality investing is an anomaly. Conventional finance wisdom holds that an investment return is a reward for risk. But quality stocks don't follow that rule. Because quality has outperformed over the long run, but it's done so at a lower realised risk than the broader market.

And that’s because many people are in the equity markets looking to get rich quick. So, they look for stocks that can go up 50% or 100% in the short term. 

Quality isn't going to do that – these companies grind out 10% to 15% year after year after year. You get rich slow from quality. You don't get rich quick.

For the get-rich-quick crowd, these more speculative companies are where the real home runs are. Tesla's a great example. It still doesn't make any money from selling cars, but it's delivered fantastic returns to shareholders.

But historically, the problem is that if you buy that kind of low profitability or speculative group of companies as a basket, you will underperform. Because as a group, they're overvalued when everyone's looking for lottery tickets.

Another secondary reason that doesn't get talked about a lot is the tax effectiveness. If you invest with a quality focus it really is a buy-and-hold, low turnover strategy, so it's tax advantaged relative to value or momentum strategies.

Three defining features of Quality

Kellie Meagher, portfolio manager, Sage Capital

A quality stock has attributes that should allow it to grow profitably with good cash flow and generate returns for shareholders that are well above its cost of capital over the long term. This will ultimately be reflected in an appreciating share price over time so quality stocks should feature in any long-term investment portfolio.

To identify whether a stock is high quality there are several key things to consider. To us, the critical attribute of a quality stock is that the company is largely in control of its own destiny and not singularly reliant on external forces such as the economic cycle to prosper and grow. That naturally leads to some sectors having a higher proliferation of quality stocks than others (for example healthcare and technology).

Another critical feature of a quality stock is that it has a sustainable competitive advantage that enables it to gain or maintain market share and pricing power. The competitive advantage can take many forms, it could be a network effect due to first-mover advantage (Realestate.com (ASX: REA)), superior technology and reputation (Cochlear (ASX: COH)), lowest cost producer (CSL Limited (ASX: CSL)) or a strong, trusted brand (ARB Corporation (ASX: ARB)).

The third aspect of a quality company is a business model that generates good cash flow - capital expenditures to maintain the business are not so high that there is very little cash flow left over. A company that can convert most of its profits into cash is at a distinct advantage as it has the flexibility to pay down debt, invest back into the business to grow or return capital to shareholders.

Other important attributes of a quality company are a good management team that thinks strategically for the long term; good ESG practices; and a board with a track record of being fiscally responsible. That last point includes things like keeping debt levels appropriate and allocating shareholder capital wisely, not just growing for growth’s sake.

All of these should result in a quality company earning a return for its shareholders well above the cost of capital over the long term, which ultimately will be reflected in an appreciating share price over time.

The antithesis of junk

Jason Teh, founder and CIO, Vertium Asset Management

I think of it in terms of both quality and junk. Quality stocks deliver high returns of capital, predictable earnings and have good balance sheets.

Junk is the antithesis of that. These companies have lower returns on capital, cyclical earnings and higher gearing.

Quality stocks should always be the bedrock of your portfolio. As Charlie Munger said, "The long-term returns of a stock is based on the company's sustainable return of capital." So, assuming a company can generate a 20% return on equity and obviously reinvests everything, you would expect 20% of returns from that company, indefinitely. This doesn't mean junk will always underperform.

An example of a high-quality stock is CSL which has a high ROE with relatively stable earnings and a great balance sheet. With these metrics the long term earnings growth generated from CSL has driven its share price to become one of the most successful listed Australian companies.

Junk stocks on the other hand tend to be trading stocks. They deliver poor long term returns because they are bounded by poor fundamentals. However, this does not mean junk will always underperform in the short term. For example, Virgin Australia is a low-quality stock because of its low ROE, cyclical earnings and over-geared balance sheet. 

If you were smart enough to buy Virgin at 5.5 cents on 23 March 2020 at the height of the COVID crash and sell it 10 days later at 8.6 cents you would have netted a wonderful 56% return. Quality stock cannot generate that sort of return in such a short period of time. The Virgin example highlights that in the short term powerful rallies do exist but in the long term the business fundamentals catch up. Virgin declared bankruptcy shortly after its rally from its lows.

The reason I bring Virgin up is that it did go bankrupt. If you didn't get out, that's it. Your 5.5 cents is worth zero. If you were quick enough to get in and out, you're a winner, but you could say the same thing about Bitcoin.

In a nutshell

We can all probably reel off a handful of Quality stocks - finding them isn't the hard part, the challenge is knowing whether the market is already pricing in the balance sheet health and years-long projected ROE that makes them worth your coin. As with all investing, it seems Quality investing is a combination of art and science, requiring a combination of "qual" and "quant" work to spot the stocks capable of grinding out 10-15% returns for a decade or more.

Stay up to date with this series

Make sure you "FOLLOW" my profile to read the rest of this series. In part two, the three portfolio managers will discuss how long a Quality rally could last; and in part three they dig into a few of their top stock tips from the Quality universe.
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