What is Quality?
My daughter and son-in-law recently purchased a new home. The house has an extra bedroom and we happened to have an extra set of bedroom furniture. Since the bedroom was there and our set needed a new home, I loaded up “Big Red,” my 2001 Chevy 2500HD Silverado pickup, and made the trek to Florida. A secondhand set of bedroom furniture is not necessarily an extraordinary or, for that matter, welcomed gift, but this set was special. It was the first new furniture my wife and I ever purchased, well over thirty years ago. Money during that time was tight, as it is for many young couples. Our home was decorated with the best furniture one could acquire at the thrift store for a few dollars. Quality usually took a backseat to price. This set of furniture was a stretch on our budget, yet we knew that it would last a lifetime. A simple design made of solid oak and capable of handling anything three young children and a dog bent on destruction could conjure up in their minds. This bed, chest of drawers, dresser and nightstand not only made it through the last thirty years, but it will probably easily make it through the next thirty years in Andrea’s home.
Our oak furniture met my definition of quality, which is the ability to withstand the destructive force of change for years and still be able to last another lifetime. Your definition of quality, however, may be completely different than my own. The subjective nature of the word “quality” can lead to a high level of confusion. Jim Wade of the Business Improvement Network, an organization dedicated to advancing quality improvement in business, states it this way:
“I don’t know whether to laugh or cry when I hear yet another group of quality professionals debating that perennial topic: “What is Quality?” Call me impatient, but shouldn’t you have figured that out years ago? Actually, I tend to cry because it’s really not funny. It’s a major barrier to effective communications between the profession and everybody else, particularly managers. How can they be helped to work towards “quality” when their advisers are unable even to agree on what the word means? “Exceeding customer satisfaction, “fit for purpose”, conformance to requirements – the sheer variety of options demonstrates the rife confusion”. ( Soapbox, pg. 14, August 05)
The confusion over a definition of “quality” may be the single greatest reason that “quality” has never been given its own status as a separate investment management approach equivalent to value or growth. Most of us know that we tend to be our own worst enemy. We want to buy stocks only after they have appreciated in price and we want to sell stocks only when they have suffered through a period of decline. The worst of these two is the latter, selling after a decline. The fear of losing everything can overcome us to the point where we just want to sell everything. If we take action and sell, which the majority of us do, it can take months, if not years, for the fear to subside, and we then tiptoe back into owning common stocks.
In seeking a method to contradict these emotions of fear and greed, I became aware of the power that “blue chip” stocks have over my emotions. Owning a large and powerful company with a long history of surviving through good economies, bad economies, wars, depressions, bubbles, and bear markets, and knowing that my company, the one I own shares in, will be in business longer than I will be alive, gave me the courage to hold on.
Overcoming fear and greed is one thing, but we also need to make a quality return from our quality holdings. There is limited study on quality and results, so it was a pleasant surprise when I opened the latest issue of the CFA Institute Magazine. Beginning on page 8, Brian Smith, CFA of Atlanta Capital Management, provides a compelling case for quality investing which we will explore. First, however, I want to share with you the results of a study covering the years 1983 through 1995. The study, “Are High-Quality Firms Also High-Quality Investments?,” was published by Peter Antunovich, David Laster, and Scott Mitnick for the Federal Reserve Bank of New York in January 2000.
Are High-Quality Firms Also High-Quality Investments?
In lieu of using an arbitrary calculation based on size, earnings growth or dividends etc., the authors of this study chose to use the results of a survey conducted and published annually by Fortune magazine, entitled “America’s Most Admired Companies.” The survey is sent to thousands of executives and analysts. Participants are asked to rate the largest companies in an industry from best to worst on a number of quality measures. The scores are compiled and the overall score determines each individual company rank. The study uses this rating as a proxy for corporate reputation.
The rated companies are then divided by deciles with the top decile (highest ranking) considered high-quality, the lowest decile considered low-quality, and the remaining eight deciles lumped together as “others.” The results are compelling.
“High-quality firms are also found to yield abnormally high returns, judging from their strong performance against the market….we measure the returns of these firms against a market index-a benchmark portfolio of all stocks listed on the New York Stock Exchange, the American Stock Exchange, and NASDAQ—weighted in proportion to the firms’ respective market capitalization. The most-admired firms outperformed the index by an average of 3.7 percent per year, while the least-admired firms lagged it by 1.6 percent per year. This pattern is consistent throughout the five years after the survey: each year, the most admired firms fared better than the market, while in four of the five years, the least-admired fared worse.”
A 3.7% outperformance may not seem substantial; however, in looking at the difference over a five year period, this small outperformance increased cumulative returns 56.25% compared to the index. The authors added this commentary:
“The abnormally high returns generated by the shares of the most-admired firms suggest that corporate reputation, as perceived by industry executives and analysts, is not fully reflected in the current stock price. This result is surprising given the characteristics of the most admired firms. They have larger market capitalization and a lower book-to-market ratio than the least-admired group—two characteristics that Fama and French (1992) associate with lower returns.”
Help from a friend
Over the years I have been privileged to meet many interesting and intelligent people. A few of these became not only friends, but teachers, and through their generosity taught me more about investing than any book, course of study, or the majority of professionals that I have met. One gentleman, long gone from this earth, was one of these individuals. He spent the majority of his life across the river from New York City in New Jersey. He retired as a Chief Financial Officer for a Mid-sized corporation that has since merged with another larger company. Like many of his depression era peers, he moved to Florida once retired. After a few years, he joined the group of individuals that we in South Carolina affectionately call “halfbacks.” Halfbacks are those individuals who originally moved from the Northeastern States to Florida, but then moved “half way back” to the Carolinas. This particular gentleman’s investment goal was not to get rich quickly, and he couldn’t have cared less about the day to day fluctuations of the market. His goal was to maintain the buying power of his savings and to pass on a substantial sum to his children. As to his portfolio, he only gave me one order regarding his common stock holdings. That order was that I could not purchase any stock that did not have a quality rating of A or better by Standard and Poor’s.
I always questioned that restriction, believing that the restriction limited his potential returns. It reduced the number of companies he could own, and it would not allow us to apply any of the “acceptable” portfolio theories currently in vogue. After a few years and a bear market, I realized the value of owning only quality. His portfolio survived. It fell less than the markets did and recovered within a short period of time. In our conference room, there is a miniature prospectus encased in an acrylic block, sitting next to a ceramic bull figurine that was given to me by this gentleman shortly before his death. I plan to keep them on the shelf for a long time to remind me of one of my many teachers to whom I owe so much.
The Standard and Poor’s Quality ranking is one of the “quality” criteria tools, along with additional proprietary and non-proprietary tools, used in our second study on quality. This study, by Mr. Brian Smith, CFA of Atlanta Capital Management, is entitled “3-D Investing.”
We will let Mr. Smith explain Standard & Poor’s quality ranking:
“The Standard and Poor’s Earnings and Dividend rankings (also known as “quality rankings”) score the financial quality of several thousand U.S. stocks from A+ through D, with data going back to 1956. The company rankings are based on the most recent 10 years (40 quarters) of earnings and dividend data. The better the growth and stability of earnings and dividends, the higher the ranking.”
This study began with the Russell 3000 Index constituents. Those companies whose shares were valued at $1.00 or less and who did not have an S&P Quality ranking were removed. For the remaining companies, those with an S&P Quality ranking of B+ or better became members of the High-Quality Index. Those with a B or less became members of the Low-Quality Index. For return calculations, these indices are rebalanced monthly and cover a period of thirty years.
The results of this study are interesting and are supportive of the authors’ belief that there is a “Quality Cycle” that is “not random or totally unpredictable events.” Here is what they say:
“…The magnitude and frequency of the quality differentials are comparable to those of size and style. For example, quality is the single largest influence on performance in 10 of the 30 years shown. Also, there are only six periods when low-quality stocks outperformed high-quality stocks by 500 bps or more—1980, 1993, 1999, 2003, 2007, and 2009. In the other 24 periods (80 percent of the observations), high quality dominated low quality or lagged it by only a modest amount.”
As the study states, low quality dominated high quality in 2009. This has continued into the current year with low-quality continuing to dominate. If this study is accurate, then the “Quality Cycle” will begin to favor high-quality holdings within a short period of time.
Some Final Thoughts
Most mutual funds and separate accounts are designed and structured to meet the needs of asset allocators. These asset allocators are in turn designing highly diversified portfolios around the Fama & French’s three-factor model. This model takes into account market volatility, value versus growth styles, and size: small versus large. Quality is not considered an important element. However, it should be.
Disclosure: No positions