Quality Matters: 3 rules for long term investors
Markets become volatile as a result of uncertainty, something demonstrated only too clearly by recent trade negotiations between China and the US, and the spectre of an uncontrolled Brexit. The good news is that volatility and challenging economic conditions don’t spell disaster for equity investors. On the contrary, investment managers able to identify quality and value will stand the test of time—ignoring the slings and arrows of short-term market fluctuations —and produce long-term investment performance.
What specific issues do investment managers face today?
Technology, and the pace of technological change, is impacting all industries not just tech stocks.
From consumer staples to industrials, technology is changing forever the way business is done and, for many management teams, keeping up with the pace of change is challenging. Increased access to information via the internet has allowed for price transparency in a variety of businesses in a way which was not possible in the past.
We have observed pressure on distribution models happening hand-in-hand with increased price transparency driven by increased access to information. Consumers can see prices across markets easily in many cases, so the ability of a business to maintain price (and price differentials) has been eroded in many instances. As a result, it is incumbent on businesses to respond to these challenges in new ways, and only some will ultimately be successful.
In our view, there are three rules which, when applied rigorously, can help investment managers generate long-term performance in rapidly changing market conditions.
Rule #1: Unconstrained universe with a disciplined process
Businesses that focus on the best ideas, and execute well, will ultimately perform better than their peers.
These businesses exist across sectors and geographies and are not limited to a single style characteristic of ‘growth’ or ‘value’. Thus, a highly disciplined research process that isn’t constrained in terms of the universe of stocks it starts with may be better placed to identify these businesses.
On the face of it, unconstrained choice with a disciplined process may appear contradictory, but in fact, it is a powerful discipline. We have employed this discipline to keep us on track as we seek to identify the best ideas. Specifically, it has enabled us to focus on the following drivers of alpha: quality, intrinsic value growth and valuation.
Quality has a number of dimensions, including the sustainability of the company’s business model in its given market, the strength of management and their ability to allocate capital, as well as ESG considerations.
Intrinsic value growth speaks to the company’s capability to grow profits and specifically free cash flow. Quality businesses are better positioned to grow their intrinsic value; it is the combination of quality and intrinsic value growth which generate a ‘duration effect’– in other words, they add value to a stock over time.
Valuation – Many commonly used metrics, like 12-month forward price/earnings ratios, do not capture the value derived from a quality company’s ability to sustainably grow its free cash flow over time. For that reason, we are not focused on relative valuation metrics in our valuation of businesses.
Rule #2: Invest only in the best ideas
It is important to stress that being unconstrained doesn’t mean a portfolio of hundreds of stocks. A concentrated portfolio can be a good thing, if you are concentrated in quality. As important as diversification is, in our view, a concentration of very good ideas is always better than a broader portfolio which (by default) would include less good ideas. There is nothing to be gained by allowing good investment ideas to be diversified away.
Rule #3: Invest for the long-term while using short- term volatility to your benefit
The ultimate aim of deep fundamental research on quality and value is to produce long-term returns by taking advantage of key inefficiencies – in terms of duration and mispricing.
To capture the benefit of the duration effect an investor needs a longer-term view. That said, short-term market volatility is often driven by more macro-oriented events and the underlying fundamentals of a business have not changed. By continuing to focus on long-term alpha drivers in periods of market uncertainty, investors can build position sizes in favoured stocks (or trim positions that have not done well).
The bottom line? Going global makes sense for Australian investors
International equities provide welcome diversification for superannuation funds, particularly at a time when their ability to invest large, and growing fund flows in the domestic market is becoming challenging. Looking over the horizon offers the possibility of investing in an unconstrained universe of stocks, but identifying the best ideas and quality companies means sticking to a disciplined investment process in all market conditions.