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Shades of Quality

David SouccarBy David Souccar
Portfolio Manager and Senior Research Analyst
Vontobel Asset Management

When we started the Quality Growth boutique in 1984, we set out to apply the tried-and-true approach of great investors, such as Warren Buffett and Charlie Munger, in a way that combines growth with downside protection. At the time, most equity managers were defined as either growth or value; quality was a niche. Today, quality is a popular approach for a simple reason – it has worked. Investors now have access to a rainbow of strategies that are considered quality, many of which perform differently depending on the market environment.

Quality attributes – such as pricing power, barriers to entry, and strong competitive advantages – can lead to more predictable earnings that compound over time and help provide downside protection. Since 2009, the S&P 500® Index accumulated 400%, compounding at 13.5% per year.1 Market performance in the previous two decades, at 6% per year, paled in comparison. In a bull market, when a rising tide lifts all ships, downside protection is underappreciated. We think this may change.

In this recent bull market, multiple expansion disproportionately contributed to total shareholder return. As the global economy reopens and interest rates rise (the degree to which will depend on the inflation rate), multiple expansion may not just become less relevant for total shareholder returns but may actually turn into a headwind.

Figure 1: Multiple Expansion Became a Large Part of Total Market Return in the Last Decade S&P 500 – Next 12 Months Price/Earnings (NTM P/E)

Shades of Quality: Figure 1 Multiple Expansion

Source: FactSet, Vontobel Asset Management as of 5/31/21.

This is important for two reasons: First, as earnings growth becomes a larger component of equity appreciation, investors will prioritize current business fundamentals in stock selection. We welcome this shift as stock picking is our craft. Second, investors’ mistakes will become more apparent when multiples turn into a headwind. As such, more predictable business models may become fashionable again.

While investors may agree on the basic principles of quality investing, there are many subtleties and nuances in defining a quality company. This article outlines our five quality convictions that may differ from other managers. 

1. Promising Business Models Don’t Always Make Quality Companies

Investors are always on the prowl for the next big idea. Who will be the next Amazon, Apple, or Google?  In the search for riches, people forget that for each Google there are multiple Yahoos. Speculative business models are engines of innovation and progress and they are an important part of the economy, but do they belong in a strategy that hopes to protect on the downside?

I keep a copy of the book “Lessons from the Top”2 on my desk and I re-visit it every time I have the urge to do something stupid. The book, published in the late 1990s, is a series of profiles of the most popular CEOs at the time. Not by design but in hindsight, the book turned out to be a “who’s who” of companies that blew up, CEOs who committed fraud, or both – e.g., Bernie Ebbers (MCI WorldCom), Kenneth Lay (Enron), and Steve Case (AOL), to name a few. It gets better—Rajat Gupta, the ex-CEO of McKinsey convicted for inside information, wrote the foreword.

The chapter on AOL is illustrative. In the early 90s, AOL was the most promising internet company. It invested heavily in marketing by seeking to acquire customers through its ubiquitous CDs. Customers would install a CD in their computer to access the service using a dial-up modem at a whopping speed of 56 kbps, slow enough to sip a cappuccino while waiting for a web page to download. AOL was an amalgamation of news, email, chat rooms, and shopping. The brand was so popular it became the inspiration for “You’ve Got Mail,” the blockbuster movie starring Tom Hanks and Meg Ryan.

Steve Case, AOL’s founder and CEO, had a clear vision for the business that is hard to disagree with, even today: “…we must believe passionately about the possibilities of what could happen, if we had a society where everyone was connected. But at the same time, if we are so focused on the promised land…we’ll never get there. So, we have to strike the right balance between vision and passion….” In fact, Steve Case was so passionate about AOL that in 2000, he convinced the shareholders of Time Warner, one of the largest media companies at the time, to merge in exchange for AOL’s worthless shares. Unfortunately, vision, passion, and scale were not enough; AOL is in the corporate graveyard of transformational companies.

To be clear, we are not against investing in technology companies. We are shareholders in some of the largest tech companies today. However, we believe being right is more important than being first. We are adamant that a company have a minimum track record of profitable growth to be considered for investment. If a company is really transformational, rest assured, the business will not go ex-growth after five years or so. If you invested in Amazon in 2010, 13 years after its IPO and with a 5-year track record of profitable growth, you would still have multiplied your original investment by 25 times.3

2. Value and Quality are Not Necessarily Mutually Exclusive

I have yet to find an investor who looks to buy high and sell low. Investing and value generation are joined at the hip. There is, however, much confusion about the meaning of value. Value, as most people understand it, is to invest in companies that are out of favor, trading at low multiples, with the expectation that the market will eventually value the stock appropriately. By this definition, quality stocks, which generally trade at a premium to the market, are perceived as “expensive.”

We would argue that this is a narrow definition of value investing. In fact, low P/E stocks can be overvalued. For example, in 2001 Costco traded at a premium of 50% to Tesco (28 times vs.19 times P/E); however, its premium is even larger today and Costco’s stock is 10 times more valuable than Tesco’s. During this time, Costco’s earnings grew by eightfold, and Tesco’s declined slightly. In our view, value is the accumulation of capital over time through the compounding of earnings and free cash flow

Figure 2a: Tesco vs. Costco – Returns

Shades of Quality: Figure 2a Tesco vs Costco Returns

Source: FactSet, Vontobel Asset Management as of 5/31/21. Past performance is not indicative of future results.

Figure 2b: Tesco vs. Costco – P/E NTMs

Shades of Quality: Figure 2b Tesco vs Costco PE NTMs

Source: FactSet, Vontobel Asset Management as of 5/31/21. Past performance is not indicative of future results.

3. Earnings Growth is Not Synonymous with Quality Investing

As discussed above, value increases with the compounding of earnings, to a large extent, yet the inverse is not always true. Earnings growth does not always create value. This is a subtle but important point. Value creation depends not just on earnings growth but also on a company’s rate of return.

Let’s imagine you start a chain of fast food restaurants, “McTobel,” and decide to expand across the country. A new restaurant costs $1 million to open and you expect it to generate $100k in profits after a year. You are an ambitious entrepreneur and plan to quintuple your restaurants in the next 10 years. You raise $2 million from friends and family to start the business, enough to open the first two new restaurants with a plan to finance the expansion with internal cash flow. After two years, the business is making $200k and you realize that at this pace, it will generate just enough cash flow to open five stores, well short of the original 10-store plan.

You decide to borrow the capital shortfall of $5 million at 10% per year from your local bank. You meet the original target, yet at the board meeting you find yourself explaining to shareholders why profits were 30% short of the original forecast. Ultimately, you realize that to expand the business with internal cash flow only, you must improve returns to at least match the rate of expansion. Otherwise, you will have to keep accessing external capital, either with debt or equity, to finance the cash flow shortfall, and earnings will continue to be short of expectations.

Figure 3: Hypothetical Example: McTobel Fast Food Chain Earnings Growth

Shades of Quality: Figure 3 Hypo Ex McTobel Earnings Growth

Source: Vontobel Asset Management.

This simple tale illustrates the challenge of investing in growth stocks. In the excitement of finding the next big idea, such as home appliances in the 1950s, internet routers in the late 1990s, or renewable technologies today, investors confuse top-line growth with earnings growth.

A real-life example is Orsted, a global leader in offshore wind energy. While we believe in the role of renewable power to reduce CO2 emissions, we are also respectful of an important concept in finance – trees do not grow to the sky. Orsted is a leader in its industry with deep know-how in identifying and developing offshore wind power plants that range 30 to 40 miles from the coasts. Still, it competes for projects with other competent operators that have access to the same technology, government subsidies, and wind patterns. As such, over time, we would expect Orsted’s return to converge to utility-like ROEs of 8% to 10%. This is not the market’s perception. The stock trades at 42 times P/E and sell-side consensus expects earnings to compound at 20% during the next five years. For Orsted, as with our fast food tale, the gap between returns and growth expectations looks wide to us.

4. Downside Protection is Not an Afterthought

It takes money to make money. If your investment is down 50%, it will have to double before you recoup your losses. The world is too complex for us to make directional bets, either because of too many known unknowns (e.g., macro risks) or unknown unknowns (e.g., a global pandemic). For this reason, in addition to sticking to our approach in seeking quality companies, we also aim to build portfolios with downside protection in mind. In The Not So Secret Sauce of Portfolio Construction, we explain our investment approach, which is to essentially find a balance between maximizing total return and minimizing downside risk.

Ideally, we would like to invest in stocks that have both characteristics; in reality, most of the time great businesses do not come cheap and valuation is part of our risk assessment. Just like we do not enjoy paying insurance premiums, minimizing risk in a portfolio requires finding the right balance between higher growth/higher multiple stocks and lower growth/lower volatility stocks. In a momentum market, when the wind is at your back, it is easy to downplay the risks and to focus solely on maximizing growth, but when your house is on fire, you will be happy to have paid those premiums.

5. Frogs Don’t Turn into Princes

It is always tempting for managers to drift in style during periods of underperformance. In this regard, our position is clear: Quality does not change with relative performance and trying to time the market is not worth the risk. During the internet bubble, some argued that “eyeballs” should replace earnings as a profitability yardstick. Today, some would argue that style drift is the preferred style; we disagree. 

For example, banks rallied in the last six months as investors were looking for a way to profit from the re-opening of the economy after COVID-19. This is understandable, considering that banks had underperformed for the last decade and were trading at a historical discount to the market. Nevertheless, except for a handful of banks, most of them look more like frogs than princes to us. 

Banks offer commoditized products. With barely a difference between a mortgage from Bank A or Bank B, customers ultimately look for the lowest rate. Scandinavian banks are more profitable than German banks because the market in Scandinavia is more concentrated and consumers have fewer choices. Technology, though, is lowering the barriers to entry and enabling financial technology (fintech) companies to take more control of the customer’s relationship, leaving the banks with credit risk. Ian Chun, Vontobel’s fintech analyst, maintains that some fintechs are poised to take share from traditional banks. Paytm in India, for example, introduced a super app in which customers can access a multitude of financial products from different banks in one place. Chime, in the U.S., is one of the many new online-only banks that leverage the lighter overhead of not managing physical branches to offer cost-competitive products like no-frills zero-fee accounts, attractive interest rates, and a digital customer-friendly experience.    

The thesis that banks will become more profitable as rates rise is true for a period. Ultimately, in a competitive industry, players will struggle to raise prices and maintain higher margins. The performance of M&T Bank over the last 20 years is a good example. M&T, despite being one of the best managed banks in the U.S., in our view, has maintained a relatively stable return on assets (ROA) regardless of interest rate levels. The return on equity (ROE), however, has moved up and down over time because of a change in the leverage ratio.

Figure 4: M&T Bank

Shades of Quality: Figure 4 M&T Bank

Source: FactSet, Vontobel Asset Management as of 12/31/2020.

Conclusion

At Vontobel, our value proposition is simple. To consistently compound our clients’ wealth over the long run, we seek to invest only in quality companies, those with a track record of growth and high returns. We also recognize that past performance is no guarantee of future performance and sometimes we will make mistakes. Nevertheless, our approach has historically offered lower risk and helped to protect on the downside.

There are many types of quality strategies, and while some will perform better than others in different parts of the market cycle, we will stick to our discipline. We do not approach investing as a beauty contest with the goal of maximizing inflows. We are here to help our clients reach their financial goals, which requires a thoughtful and consistent process. Our quality growth approach may not be for everyone, but we believe it is the right strategy for investors looking to compound wealth and sleep well at night.

1As of December 31, 2020.
2Thomas J. Neff and James M. Citrin, Lessons from the Top: The 50 Most Successful Business Leaders and What You Can Learn from Them, Crown Business, 1999.
3Assuming stock price as of December 31, 2010.

The views and opinions expressed are those of the individuals mentioned above and do not reflect the opinions of Vontobel Asset Management or Vontobel Group as a whole. The views may change at any time and without notice. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.

Past performance is not indicative of future results. Any companies discussed are for illustrative purposes only and may or may not currently represent a portfolio holding.

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