A quality portfolio may contain stocks with growth and value attributes. It also moves away from size bias given both small and large companies might have quality attributes.
Benjamin Graham, known as the father of value investing, actually classified stocks as either ‘quality’ or ‘low quality’. Graham observed that the greatest losses result not from buying quality at an excessively high price but, rather, from buying low quality at a price that seems like good value.
In 2000, a professor of accounting at the University of Chicago, Joseph Piotroski, published a paper that looked at whether it was possible to improve a portfolio of value stocks by eliminating those of lowest ‘quality’.
He produced a nine-point scoring system to identify quality. Piotroski has become a celebrated academic on quality investing.
In 2013, another US academic, Robert Novy-Marx, made a significant contribution to the quality debate when he found that gross profitability – revenues minus cost of goods sold, scaled by assets – has as much power predicting stock returns as traditional value metrics.
No discussion of quality would be complete without reference to Benjamin Graham’s most famous student, Warren Buffet, who famously noted that it’s “far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price”.
In short, quality can be an elusive characteristic, with a number of studies identifying different factors that support the definition.
At DNR Capital we have settled on five factor headings, which incorporate the Piotroski scoring system and added the ingredient of environment, social and governance (ESG) engagement.
The quality factors we follow are:
- Industry positioning – an analysis of the industry to assess the robustness of current earnings levels and the potential of threats from new entrants, competitors, substitution and supplier and customer initiatives;
- Earnings growth – companies are scored on return on equity (ROE), change in ROE, margin, change in margin, volatility of forecasts and EBITDA as a percentage of cashflow;
- Balance sheet – companies scored on net debt to equity, net debt to EBITDA and interest cover;
- Management score – a subjective measure based on the portfolio managers’ experience, including the company’s history of allocating capital well; and
- ESG score – derived from the DNR Capital socially responsible assessment utilising Bloomberg as well as internally researched information. Key regard is made to tail risks that could impact valuation.
We believe, though, that it is not enough to focus solely on quality. Growing evidence and, indeed, DNR Capital performance suggests a valuation overlay is critical to exploit the opportunities that can arise where quality holdings are mispriced.
Our investment philosophy focuses on quality that we believe will enhance returns through the cycle, returns can then be further enhanced by focusing in on buying quality companies when they are out of favour as identified by our detailed valuation analysis.
Quality stocks
The Australian market yields an investment universe of only about 70 stocks that fit DNR Capital’s quality and liquidity filters. We choose between 20 and 30 of these stocks for our concentrated portfolio. The value component tends to extend the cycle of expected outperformance from the quality components. Quality stocks usually hold up well in down markets but will underperform when the market gets toppy.
A recent addition to our Australia Equities High Conviction Portfolio demonstrates our quality filter in action.
ALS is a global leader in providing laboratory services. It has long been known as a specialist provider of minerals analysis but in recent years has grown out its environmental and food testing businesses.
In fact, around 60 per cent of its earnings are now derived from defensive, non-cyclical parts of its business.
Furthermore, it is strongly diversified across the globe. This diversity combined with very effective management has meant it earns circa 20 per cent profit margins and continues to earn these types of margins in its minerals division despite the strong decline in revenues as resources declined.
In recent years management blotted their copy book, purchasing an oil and gas business at precisely the wrong point in the cycle.
In order to break into the oil and gas market they strayed from their core area of expertise (lab testing) into some lower margin and lower quality ends of the market.
Private equity has opportunistically launched a bid at $5.30, attracted to the value in the business. From our perspective we see this price as too low and we were happy for management to reject at that price. We see a number of long term opportunities:
- Life Sciences – The life science business has been growing at 10 per cent plus as it takes market share across the globe;
- Minerals – The global minerals exploration budget has moved from $22 billion to $7.5 billion in recent years. ALS has done a good job to gain market share during the decline and has managed its cost base effectively. We estimate it has grown market share from 30 per cent at the top of the cycle to around 45 per cent. Lead indicators suggest we have seen the bottom of the exploration budgets; and
- Food – Management has presented the potential to grow the food testing business. This is a growth area given governments and consumers are increasingly concerned with product quality (health, allergy trends) and ALS is in a strong position to leverage their laboratory expertise.
Increasingly, there have been some quantitative studies performed to identify whether alpha can be generated by focusing on quality.
Evidence suggests that funds that held stocks that exhibited low quality characteristics significantly underperformed those with higher quality characteristics.
Ultimately the utility of quality investing will be judged by results.
Jamie Nicole is the chief investment officer and co-founder of DNR Capital.
