Graham observed that the greatest losses resulted not from investors buying quality at an excessively high price, but from buying potential value traps (low quality at a cheap price).
In contemporary markets, quality companies continue to exert a powerful pull on portfolio construction, but the real power in harnessing these stocks comes from the ability to lay additional screens over the investment selection process.
In our view, a quality company is one that recognises the benefits of having best practice ESG (environmental, social, governance) policies as well as good fundamentals.
Sparse opportunities require a more detailed search, and most financial analysts tend to ignore ESG risks when valuing companies. However, the benefits of strong ESG policies are often under-estimated.
Factors like these can hold a special place in understanding particular stocks and sectors in high conviction portfolios.
For instance, corporate governance – as part of the ESG triangle – plays an increasingly influential role in how a company manages its relationships, particularly how a company’s management, its board and its shareholders deal with each other and through external relationships (such as suppliers), with an ultimate goal of reducing conflicts of interests and acting in the best interests of stakeholders.
Strong corporate governance has an established link to performance and outlook for the business, which in turn impacts its capital investment and strategies.
The five point plan
As an independent investment manager, Dalton Nicol Reid uses a five-point quality matrix to identify relative quality of listed companies. This includes balance sheet assessment, industry structure, management, earnings strength and of course, ESG policy criteria.
Research on quality investing has largely focused on the back testing of various quality screens to determine the impact of quality on returns. On the whole, this research has shown a strong links between quality and performance over the medium and long term.
A quality portfolio will be agnostic to value or growth and moves away from size bias, given that both small and large companies may have quality attributes. Following a quality investment approach allows us to identify companies that are mispriced by overlaying this quality filter with a strong valuation discipline. It also allows us to enhance returns by identifying companies when they are out of favour.
New opportunities?
Right now, the market may be at turning point with a continuation of the low interest environment, and the potential re-emergence of the domestic cyclicals as the resource sector slows.
With bond yields hitting lows, strong companies with sustainable profit growth will become more attractive to the value investing community.
Concentrated high conviction portfolios really have to stand the test of time in terms of track record, and our run of positive returns over the past decade shows that quality investing works best when the right filters are in place, and investment decisions are made on the details.
Jamie Nicol is chief investment officer and director, Dalton Nicol Reid
