In my first two articles in this series, I described and evaluated the pros and cons of some of the most popular equity investment styles, including value, momentum, size and low volatility. This time, I’ll discuss the quality approach and how different investment styles influence our philosophy.
Quality is an approach where the asset management firm seeks out the stocks and shares of high-quality companies that are trading at a fair price. By contrast, the aim of funds and asset managers who follow the value style is to invest in good companies that are trading at a discount to their intrinsic value.
The definition of quality can vary between asset managers, but common characteristics of a quality company include good leadership and governance, well-run operations, high levels of free cash flow, and a business model that gives it a competitive advantage. Its advantage could come from its intellectual property, brand, value chain, and its power to dictate product pricing to the market.
With an ‘economic moat’ protecting its business, a quality company will be a leader in its industry, well positioned to take advantage of tailwinds and to weather the headwinds. It will have strong finances—solid balance sheet, good return on equity, and a track record of reliable earnings growth—and an attractive, but not necessarily low valuation.
Quality equities tend to have more predictable earnings and cash flow growth than value equities, and hence a portfolio based on quality companies should deliver good long-term capital growth, but in a more consistent manner than lower-valued companies. Quality portfolios will generally perform at or close to the levels of the index benchmark in upward markets and outperform the index when the market is trending downwards.
The reason we favour this approach when we are choosing funds for our clients’ portfolio is that it balances growth in rising markets with risk protection in market downturns. But we complement the focus on quality with elements that enables us to capture the growth of the market via passive or index-tracking funds.
Our investment philosophy is made up of three components that, together, aim to deliver the best possible risk-adjusted returns for our clients:
- The most cost-effective and efficient tracking funds give us our beta baseline. They provide long-term growth and returns in line with high-level market indices (such as the MSCI ACWI or the ALSI) and reduce the cost of managing the overall portfolio. These investments have a natural bias towards momentum and growth because the companies with the largest market capitalisation will have a higher weighting in the index.
- Smart beta funds are the second pillar of our approach. Such funds blend elements of active and passive strategies and aim to beat the market. These funds usually track a particular style, or combination of styles – for example, momentum, value or growth– but do so in a mechanical or objective manner. Smart beta funds offer the ability to pursue higher returns than the market, but with the lower costs of a passively managed fund. (Check out our articles on passive investing and smart beta to learn more.)
- Active managers who focus on quality are the third key component of our approach. This provides our clients with risk management, predictability and diversification away from market cap weighting. It aligns with our philosophy of achieving long-term returns in excess of inflation whilst managing downside risk.
A portfolio, in our view, should be diversified in terms of industrial sectors, assets and geographies to manage risk and reap long-term portfolio performance. Over the years, we have proven that this approach delivers optimal long-term returns while shielding clients from market turmoil or volatility in particular geographies, equities or asset classes.