Cheap Quality – No oxymoron in the UK

Harmful Generalisations

The perceived opposing investment styles of value, income and growth is a perplexing concept. To me, it conjures up imagery of investors huddled into the extreme corners of an equilateral triangle.

A lone voice pipes up: … “I’m a ‘quality’ investor. In which corner do I belong?”. “Get in the growth corner and be quiet” bellows the market.

Unfortunately, quality is a subjective term, and this subjectivity breeds misunderstanding and generalisations. The most damaging of these misconceptions is an association between quality and growth. The result of this is that quality is often labelled as expensive. You won’t be surprised to hear I vehemently disagree with that conclusion. Indeed, quality investing in the UK has rarely been cheaper.

Evaluating quality

Quality, for us, is about a virtuous circle of wealth creation. It’s not about any one metric, but a blend of characteristics that allow companies to compound economic value over time. Sustainable growth is just one of the 10 characteristics we evaluate a company on. On top of that we look for a high return on invested capital, the ability to defend those returns and reinvest them. We also require efficiency in turning profit into cash, discipline around capital allocation and a balance sheet that protects against shocks. Finally, we target corporate governance structures and management teams that understand profit maximisation, capital allocation and remunerating shareholders. If a company can execute in each of those aspects, then we judge it to be a high quality.

The damaging association with growth

So, why is the association with growth so damaging to quality’s perception? Anyone who follows equity markets will know that the ‘growth’ index has outperformed ‘value’ since the financial crisis. Despite the sharp rotation back to value since October, the 10-year trend has been a painful performance pill to swallow for value managers. Continued faith in their strategy lies in the belief that ‘growth’ has had its time in the sun and that value’s historic dominance will reassert itself. This is the ‘the rubber band effect’ that my colleague, Dan White, has written about so astutely.

Surprisingly, I don’t disagree. The issue I have is that the growth index is a terrible construct, calculated principally by measuring earning-per-share (EPS). Bottom-up investors should know that EPS is an awful proxy for sustainable growth; open to manipulation and the promotion of unhealthy behaviour. These are not characteristics I would associate with sustainable quality by any means.

So yes, the value index should outperform an index that celebrates unsustainable EPS momentum. It’s this association with an ill-conceived index that has performed so well that leads to quality being stereotyped as expensive. However, when you take a sophisticated approach to evaluating quality then the investment proposition looks far more attractive.

Quality in the UK has rarely been cheaper

It is often said that fund management is an art and not a science. This is true to a degree, but why not use science to educate and elevate the art? We use data to create a powerful screen that evaluates company quality. I’m not talking ‘big-data’, just ‘a-lot-of-data’. The screen gives each company a score out of 10 based on the quality characteristics mentioned earlier. We’ve then cross-referenced this with a valuation screen and run it for 2010 vs. today for the FTSE All-Share. The results are intriguing…

The chart on the left plots the trade-off between quality and value in 2010. As you might expect, the trendline is downward sloping. This suggests that the two are negatively correlated i.e. low-quality companies are cheap and as you climb the quality curve they get more expensive.

Fast-forward to today and the chart on the right depicts a very different story. Amazingly, the trendline is now upward sloping. This is saying that stocks become cheaper as you move up the quality spectrum. You are being paid to increase quality. This relationship is very strong until you get into the top 2 deciles of quality, where stocks start becoming expensive again. Most interesting to me though is the section highlighted in green. These are some of the finest wealth compounders available, and they’re the cheapest stocks in the market. This provides a rich hunting ground for us, and we remain very excited about the opportunities here.

What has created this unique situation? You can’t write a UK focused blog without mentioning the dreaded ‘B’ word. Brexit positioning has greatly distorted the market and turned conventional pricing of quality on its head. Perceived defensives have outperformed, as have international earners. Sectors such as Oil and Gas, Materials, Utilities and Healthcare have been the obvious beneficiaries. The first three of these sectors are some of the worst scoring in terms of constituent company quality – think sub-cost-of-capital returns, high capital intensity, limited growth, poor cash dynamics etc. On the flip-side, UK domestics and global cyclicals have indiscriminately suffered. In here are some fantastic quality compounders. Brexit, for all its unintended consequences, has opened up a once in a generation opportunity to be paid to climb the quality curve.

Back to my original question: Where does quality sit within the market’s equilateral triangle? Well, it doesn’t, and maybe the market needs to free itself from harmful pigeon-holing and generalisations. If you take a more holistic approach to investing and realise that value, income, growth and quality are separate, but not mutually exclusive, then active investing in quality in the UK is a hugely attractive proposition.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.