Whilst defining quality is no minor philosophical challenge, we are fortunate that the application of the concept of quality to investing is robust to various definitions, be they qualitative assessments of competitive position or earnings quality and sustainability, or alternatively quantitative measures such as returns on capital, margins and organic growth, or even the volatility of these measures. In practical terms, quality is any characteristic of an asset that, all else equal, commands a higher price.
“Quality … you know what it is, yet you don’t know what it is. But that’s self-contradictory. But some things are better than others, that is, they have more quality. But when you try to say what the quality is, apart from the things that have it, it all goes poof! There’s nothing to talk about. But if you can’t say what Quality is, how do you know what it is, or how do you know that it even exists? If no one knows what it is, then for all practical purposes it doesn’t exist at all. But for all practical purposes it really does exist.” - Robert Pirsig, Zen and the Art of Motorcycle Maintenance.
Fairlight believes the best quantitative proxy for business quality is return on invested capital (ROIC), a measure of the return the company earns on each dollar invested in the business, calculated as after-tax operating profit divided by invested capital (working capital plus fixed assets).
Quality beats junk
There is now more than ninety years of data derived from the US market to support the hypothesis that the returns earned from investing in high quality stocks exceeds those of the general market. This is complemented by similar, albeit not as long-dated, studies in other markets which leads to the conclusion that the phenomenon is both persistent and pervasive (see Figure 1). Importantly, the quality return premium did not disappear following the first publication on the topic by Novy-Marx in 2006, further increasing its legitimacy.
Figure 1: US 1927-2015; Andrew Berkin 2016, Europe 1982-2014; Stanley Black 2015
Finding quality businesses
The key to successful quality investing is identifying businesses that can generate high levels of ROIC in the future and patiently waiting to buy them when their market valuation implies that their ROIC will mean revert.
In the classical model of capitalism, any company that is able to produce a high ROIC will have their advantages competed away with ROIC regressing back towards the mean. In practice however, we find a not insignificant number of companies that are capable of sustaining high ROICs for an extended period of time for a variety of reasons such as innovation, brand, regulatory advantages, network effects and cost advantages.
McKinsey measured the sustainability of company ROICs by categorising the market into quintiles based on historic ROIC, and then tracking the median ROIC for each portfolio over the following fifteen years. The result (shown in Figure 2) demonstrates that while there is certainly some evidence of mean reversion, the companies with historically high performing ROICs did continue to generate higher returns than the rest of the market, even fifteen years later. Put another way, historic profitability is a reasonable predictor of future profitability and time spent researching historically successful companies isn’t time wasted.
Figure 2: Koller, Goedhart & Wessels, Valuation 6th Ed. 2015
Why does quality investing work?
The classical behavioural explanation given for the outperformance of quality stocks is the investor preference for large returns over modest ones, which leads investors to overpay for “lottery tickets” capable of generating large returns while undervaluing the opportunity to compound at more modest rates but importantly with more certainty. This dynamic can also be seen in the historic outperformance of low-risk stocks (as defined by volatility) over their high-risk counterparts in almost all markets studied (Baker and Haugen 2012).
Whilst a valuation-insensitive approach has historically worked surprisingly fine, Fairlight believes that given the increasing appreciation of the merits of quality investing since the GFC (as evidenced in the stretched valuations currently ascribed to many high-quality businesses), discipline around valuation is particularly important today. While classical value investing has had a rough decade, buying companies for less than they are worth will never go out of style.
Investors have rewarded stocks demonstrating the ability to deliver growth while also exceeding market expectations. However, the multiples on some of these stocks are clearly dividing market commentators
In this episode of Buy Hold Sell, the panel put the spotlight on three emerging growth names including Citadel Group (ASX:CGL), IDP Education (ASX:IEL) and Bravura Solutions (ASX:BVS).
Tune in as Matthew Kidman from Centennial Funds asks growth specialists Prasad Patkar from Platypus and Steven Ng from Ophir for their views on these high flyers. Each of our guests also shares an emerging growth stock they believe looks attractive right now.
Click on the video below to access the latest exclusive brought to you by Livewire.
Matthew Kidman: Welcome to Buy, Hold, Sell. My name is Matthew Kidman, and today, we have Steven Ng, from Ophir, and we have Prasad Patkar, from Platypus, and we're talking about emerging growth. Don't we love growth.
First off, Steven, Citadel (ASX:CGL), an interesting one. A bit of their own software. Bit of IT services. In between two groups. Buy, hold, or sell?
Stephen Ng: That's a hold for us, Matthew. It's transitioning 30% of its revenue, at the moment, in managed services to subscriptions of service. We prefer to sit on the sidelines, as management transitions that business.
Matthew Kidman: It's a funny one, Citadel. Buy, hold, or sell, Prasad?
Prasad Patkar: It's a buy, but I agree with Steven's thought on this. Investors need to take a long-term view on this. The transition, like Steven said, is going to take a while. We've had some management fractions as well, more recently, so they all need to settle and play out. So, it's a buy, but with a long-term view.
Matthew Kidman: Okay. This one's got everything. It's got education. It's got China. It's got online. IDP Education (ASX:IEL). Buy, hold, or sell?
Prasad Patkar: It's a buy. Expensive stock, so I can see why people in the market would be concerned about it, but the runway for growth is very long. Execution has been flawless. The digital investment's starting to pay off. So, we like it. It's a buy, for us.
Matthew Kidman: You'd have to be an Olympic high jumper to get over this multiple, Steven, but it's a terrific story. Buy, hold, or sell?
Stephen Ng: It's a buy. As Prasad said, not cheap. You know, quality never is cheap. Industry leader. Long runways for growth, and it's acting ... It's in a defensive industry, and we think the market is underestimating its progression to digital, in terms of the conversions of the students coming through. It's a buy.
Matthew Kidman: Okay. Wealth management software, with a great name, sexy name, Bravura (ASX:BVS). Making an acquisition, raising money. Buy, hold, or sell?
Stephen Ng: That's a hold for us. Punchy multiple. Growing well in that wealth space, and just recently raised $165 million in capital. We wouldn't want to stand in the way of management deploying that capital into the market.
Matthew Kidman: Okay. They've done a terrific job. Came to the market a few years ago. It's been one way, upwards. Buy, hold, or sell, Prasad?
Prasad Patkar: It's a buy for us. We were sceptics on the stock when the IPO happened, because customer concentration was a big issue for us at that time. But, they have done exactly what they said they would do in the two years that they've been listed. So, they've won us over. It's a buy. I agree with Steven, that the capital raised was a little bit quirky. I mean, it was not a small-
Matthew Kidman: Opportunistic.
Prasad Patkar: Opportunistic. And, we'd like to see how they deploy it. But, so far, the execution track record's been pretty good, and you would back them. It's a large, addressable market, again, and they've executed well. So, it's a buy.
Matthew Kidman: Okay, here's your chance. Something you've spotted, that's emerging and growing?
Prasad Patkar: We like NextDC (ASX:NXT). We recommend that your viewers have a look at NextDC, from a long-term thematic perspective. Again, a very good execution track record. The tailwinds, in terms of the data creation storage and interconnectivity between data centres, and within the data centre itself, is here to stay, and it's going to be quite powerful and compelling. So, I think NextDC will do well. It's not a business that's very easy to like. It's capital intensive. It burns a bit of cash, and It's going to take a while for that investment thesis to really play out in terms of big profits. But it's something that's got long-term tailwinds.
Matthew Kidman: Alright. NextDC, you got something you can match that, or even one up it?
Stephen Ng: Yeah, sure. My pick will be PSC Insurance (ASX:PSI), a brokerage unit firm, there. Effectively trading cheaper than its peers or Steadfast (ASX:SDF) and Austbrokers (ASX:AUB), growing faster, better balance sheet, and longer runway for growth. Also, has a more aligned management team there, as well, and north of 50% of the stock. They pay themselves modestly. They're rewarded by dividend growth. So, are we, as shareholders.
Matthew Kidman: Great names, and we all prefer to emerge than submerge. I've used that one, before. That's the only problem.