The Quality factor
25 October 2022 _ News
The last element we shall consider within factor investing strategies is QUALITY.
According to the academic definition, the QUALITY style tends to involve companies with a well-defined business characterised by verifiable competitive advantages. Therefore, managers will focus their attention on companies with low leverage, stable earnings, and high profitability.
Are there points of contact between the VALUE and QUALITY methodology?
Absolutely, as both use business fundamentals. Subsequently, QUALITY delves into a number of aspects of business analysis.
In academic circles, "quality" is defined, perhaps improperly, as a defensive factor, meaning that it tends to present the best results during periods of economic downturn (the fourth and final phase of the cycle) because the operating models of these companies should remain profitable regardless of the economic cycle. Probably the best definition is homogeneity between one economic cycle and another, with behaviour that tends to be quite defensive in slow periods but also benefits from upturns in growth periods.
Of course, this style of investment must also be approached in a methodical and disciplined manner, periodically assessing the balance sheet characteristics of companies and conducting regular portfolio reviews in order to maintain a portfolio that is always well oriented to the aforementioned characteristics.
What does the historical performance analysis show?
Because of the characteristics expressed above, outperformance is evident over time, although it has been shrinking slightly in the most recent period. It is clear from the chart that the actions of central banks favoured several companies and their businesses, allowing significant improvement in accounting data, but in subsequent years, these companies have begun to stand on their own two feet by using less and less leverage, and this makes the QUALITY style stocks less vulnerable to interest rate sensitivity (a recurring theme throughout this year).
Certainly, the quality of a company is not always reflected in the stock market price, especially when factors outside the financial world and related to human emotionality, influence market values; therefore, it is not surprising when, over the course of certain periods, quality does not emerge.
The most important thing is to always check up on your portfolio by judging it objectively and in a sterile manner as much as possible through the financial statement metrics laid out in this and previous instalments: QUALITY and VALUE are the two watchwords that several veteran U.S. investors (Warren Buffett, Benjamin Graham, Jeremy Grantham of Grantham, Mayo & Van Otterloo (GMO) or economist Robert Novy-Marx) have imposed in their investment style, and history shows the results.
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