The Future of Quality in a Changing World

Read this insight if you want to learn

"Quality investing is like dieting – it is easy in theory, but in practice it requires a lot of discipline to produce good long-term results."

Many equity investors claim to adhere to a quality approach, but their portfolios comprise quite different businesses. How do you define quality?

• In our view, there is no such thing as one recipe for quality, so there is actually quite some differentiation between quality managers.
• We consider both hard and soft characteristics to define a quality business.
• The key financial metrics we look for are high return on investment (ROI), high return on invested capital (ROIC) and free cash flow (FCF) conversion. We look for consistency and stability, high margins, ideally growing ones.
• Some of the subjective factors we look for are experienced managements, transparent accounting practices, and an understandable business model, among others. We tend to like less capital-intensive businesses and less cyclical ones that have a high level of predictability and a long-term opportunity to capitalize on.

Sounds like you are very demanding about your portfolio candidates. Do you need to make any trade-offs in your search?

• A key trade-off is between quality and growth. Young growth companies can expand more rapidly than mature ones, but they might be less stable. We generally require a track-record of five years and do not invest in businesses that are in early stages to protect the capital of our investors.
• We do find companies that combine quality and growth features – they typically exhibit three commonalities: They are active in secular growth industries, they are dominant players in these industries and finally, they re-invest their earnings to expand their position in the marketplace.
• Some examples are payments companies Visa and Mastercard, and e-commerce businesses Amazon and Alibaba.

"Companies that can generate consistent and higher-than average earnings growth over the long term warrant the multiples we are willing to pay for them."

• These are great companies, but how do you ensure that there is room for further growth for investors? How do quality and valuation interact?
• While we do not want to overpay, our research shows that the best businesses are able to compound their returns over time, making the entry price much less important than the long-term growth of the company. So, we are able to pay higher multiples than investors who are purely looking for value because we select businesses that can compound over time.
• That said, the entry price is still important, so as bottom-up investors, we look very closely to justify the valuation before making any investment.

What role is value investing playing here?

• The discussion about value vs growth vs quality is mostly one for marketing experts. We think the distinction isn’t as clear as some might claim – so value and growth investing are really tied at the hip.
• If a company is trading at a low price-earnings multiple, you should be asking whether there is truly value in this company or whether it is trading there for a reason.
• On the other hand, at this stage of the market cycle, we see a lot of momentum investing, with a lack of focus on valuations.
• One does not really work without the other, to keep the stock market efficient, there needs to be times when value is important, as a reality check for investors.
• This is where quality is key as it increases your chances that growth can be sustained and therefore your likelihood for long-term success is higher.

When you established your quality approach more than two decades ago, ESG was not the buzzword it is today. What role do ESG considerations play in quality investing?

• For a quality investor, ESG comes naturally as a topic when you are looking for great businesses and great management teams. It is a key tool to identify risks in investments.
• Governance is a critical aspect in this regard. Take Japanese companies, as an example. We struggle to get comfortable with them because of management’s lack of focus on shareholders. Now things are changing for the better.
• Social issues are also an important element. For example, we closely monitor the supply chains in the apparel industry to avoid issues such as exploitation of workers.
• Environmental factors play a key role as well, but we believe you need to put this into context. Just because a company is good for the planet, does not mean it is also a great investment. For us, it has to be both.

"Our definition of quality does not change – what does change is where we find quality."

Looking at the current market that has seen a very quick recovery after the sell-off in spring: How is quality evolving over time and where do you find good quality names today?

• Our definition of quality has not changed over the 20+ years we have been following our investment style. However, what does change is where to find quality.
• As the markets focus on growth momentum, software companies have enjoyed great interest from investors, but some quality businesses from the consumer staples or health care sector have been largely ignored.
• Take medtech as an example: It clearly lacks momentum in its earnings growth as it was impacted by COVID-19 related postponements of surgeries. We expect this pent-up demand to come back as hospitals catch up on operations.
• When it comes to quality investing, we will continue to apply our tested philosophy and process.
• Our goal is the same as always, to help preserve and grow our clients’ capital with quality growth companies through the full market cycle.