One of the most successful investors of all time, Warren Buffet, once said, “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Despite the recent rise in interest associated with “quality” investing, the premise of owning consistent, profitable companies is not a new phenomenon.
In the shadows of the COVID-19 pandemic, and with more potential stressors to come, we have observed more and more investors taking advantage of the opportunity to reassess the fundamental quality of the companies within their portfolios. With revenues and profits across industries potentially at risk, those companies with strong, consistent balance sheets offer a very attractive value proposition to investors looking to weather any storm that may be ahead. This shift across the global economy has led many investors to take a deeper look at the landscape of “quality”-oriented investments. Yet for investors familiar with this space, and for those just considering it, three main questions arise in the evaluation of a quality stock allocation to their portfolios:
- What does the research show in terms of quality companies being sound, long-term investments?
- What are the various ways to define a quality company, and are there differences between these definitions?
- How does J.P. Morgan Asset Management combine all of this information into a thoughtful investment strategy?
A brief review of “quality” factor research
Let’s start by quickly reviewing some of the research on “quality” as a company attribute, and how that translates into long-term performance expectations. Quality companies can be defined in many ways, but broadly speaking, we believe that a quality company is one that has strong profitability, manageable debt loads, and consistent earnings and accounting practices, especially relative to industry peers. And, while it may seem as though most of the research related to these types of companies has been published in the last 10 years, the first references to the power of investing in higher-quality companies actually dates back almost a century. While Benjamin Graham and David Dodd’s seminal book “Security Analysis” is widely regarded as the foundation for value investing, the authors actually suggested much more just than buying inexpensive stocks. The book also laid out the fundamental importance of profitability and consistency of earnings when determining the fair value of a company. So, despite the terminology of “quality” investing being new to some, we would actually contend that it is actually one of the oldest investing styles in existence.
That said, with more and more fundamental data at all investor’s fingertips, there has definitely been a corresponding increase in the amount of research published on the topic of high-quality stocks. Despite an abundance of data showing consistent outperformance of high-quality stocks relative to their lower quality peers, the question of intuition remain. One would believe that investing in high-quality companies would be accompanied by less risk than lower quality peers, so why would investors be compensated to take on less risk? While there is no one correct answer to this question, we believe that both behavioral and structural rationale help to explain why this performance gap persists. From a behavioral standpoint, outperformance may occur because of the so-called “glamour stock” effect—whereby investors overestimate and overpay for risky, low-quality stocks that may be perceived as disruptive. In a typical scenario, investors would tend to overvalue these “glamour stocks” that have greater price uncertainty because they see greater potential for outsized gains. At the same time, consistent, high-quality stocks become relatively undervalued, thus positioned to offer increased return potential over the long term. Another potential explanation would be structural in nature. In this scenario, the lower volatility typically associated with quality stocks could reduce demand from investors that have limited, if any, ability to take on leverage. This shifts investor’s preferences to securities with higher risk/reward prospects in order to gain potential outperformance relative to their market benchmark. Again, this leaves higher-quality stocks underpriced, increasing their return potential.
Notwithstanding an absolute explanation for quality stock outperformance, we do tend to see this outperformance of high-quality stocks does persist across both time periods and geographic regions. To illustrate this, the chart below shows the annualized performance of our quality factor (which we describe in more detail below) across various regions, spanning a time frame from late 1994 to late 2020. As you can see, no matter which market you evaluate, high quality stocks have provided strong excess returns relative to their lower quality peers.
Quality stocks provide attractive returns
Exhibit 1: Excess annualized return of quality factor across all regions
How to define “quality” in factor investing
While all of that research is helpful, most investors raise the question of the ambiguity of the term “quality”: How does one truly define quality, and do the various ways to define this characteristic really make much of a difference? The short answer is absolutely! Based on years of research and implementation of factor portfolios, we believe that the most complete picture of a company’s fundamental quality should be based on three main pillars: profitability, financial solvency and accounting consistency. There is strong intuition and academic research behind each of these pillars, which we believe is an extremely important foundation for our research. But when it comes to actual implementation, we believe it is just as important to consider how each component interacts with the others. Specifically, do they help us gain a clearer picture of the company’s overall quality, or do they just duplicate the same signal, thereby making multiple metrics unnecessary. Looking at our data spanning 30 years (from 1990 to 2020), we see an average pairwise correlation between these three pillars of quality of just 0.34. This is a clear sign to us that each of these pillars gives us a unique picture of company quality, and are therefore diversifying to each other. Not only are they diversifying, but all of the pillars have also exhibited excess performance on a global basis over these 30 years. This means that, as the old saying goes, the whole is greater than the sum of its parts. Finding companies that have strong profitability, low leverage, and reliable accounting practices provides us a more complete and consistent picture of quality than any one of these signals individually.
Building a quality equity portfolio
How do you take all this information, and create an investable portfolio of quality stocks? For us, there are two critical aspects to portfolio construction that must be considered. First, a strategy must consider, and be intentional, around the allocation of sectors. We believe that quality stocks – not sectors – drive the long term excess performance relative to the market, so we believe in neutralizing sector exposure relative to the market. Second, a strategy must also consider how to balance capturing the characteristic of quality versus taking stock specific risk. We believe that casting a slightly wider net and limiting stock-specific risk can help us systematically capture quality as a factor and limit the impact of any one stock on portfolio performance.
Many investors have recently taken the critical step of reassessing their equity portfolios with a very specific focus on the fundamental strength of the companies they own. Being intentional about the quality of your portfolio is perhaps more vital now that it ever has been before, but it is just as important to know what you own and how it may deliver on those expectations. The Quantitative Beta Solutions team at J.P. Morgan Asset Management has over a decade of experience focused on researching and implementing efficient, thoughtful and intuitive quality portfolios. The JPMorgan U.S. Quality Factor ETF has this expertise embedded in its process, yet also offers a cost-effective and tax-efficient way to enhance an investor’s portfolio level exposure to high-quality companies.
JQUA RISK SUMMARY: Investments in mid cap companies may be riskier, less liquid, more volatile and more vulnerable to economic, market and industry changes than investments in larger, more established companies. Share price changes may be more sudden or erratic than the prices of other equity securities, especially over the short term.
Originally published by J.P. Morgan, 11/19/20
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