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It is unquestionable that when it comes to investing on the stock market one has to think long term. Shares go through short term cycles of good and bad performance. Stock pickers tend to focus on a particular investment style to try and pick winners that they believe will deliver good returns over the long term. In this article, I look at two of the commonly used styles, quality and value.
Source: Seed Research (November 2017)
Value investing is probably the most well-known investment style and is commonly taught in academic literature. The investment style focuses on companies that trade below their intrinsic value (the perceived true value of the share as per the manager’s valuation method). The assumption is that value of the share will revert back to its intrinsic value thereby giving the investor a profit opportunity.
Quality investing on the other hand seeks to identify great businesses that consistently make a return on capital above the cost of capital, thereby creating value for the shareholder. There is less emphasis on price as the belief is that these type of companies possess fundamentals that create value across the business and economic cycle. Characteristics of such companies include strong management teams, low debt and stable earnings growth.
In comparison to the value style, quality investing tends to hold stocks in the portfolio for longer periods which reduces trading costs. A breach in the investment case (quality criteria) thus an inability to create value across the business and economic cycle would be a reason to exclude a stock from the quality portfolio. Value managers tend to keep their stocks until they reach their intrinsic value (which can be a long cycle) but however do tend to trade more than quality managers. This can be as a result of stocks reaching their intrinsic values therefore the need for new opportunities and also if the catalyst to unlock value fails to materialise.
Source: Morningstar Direct (November 2017)
An analysis of the performance as shown in the chart above shows cyclicality in performance of the styles. The rolling 5 year returns over the period January 1997 to October 2017 shows that both value and quality outperform at different times. Over the whole period, quality has delivered better returns with lower volatility. A 50/50 blend between the two styles shows also good volatility and return characteristics.
At Seed, we like the quality style but are also cognisant of the fact that the investment styles perform better under different market conditions. As such, to get the best outcome for our clients, minimising volatility, we blend the styles where appropriate, paying attention to prevailing market conditions. Over the long term, we subscribe to the notion that investing the quality businesses that consistently create value will result in a better outcome for the investor.