Benjamin Graham is generally considered to be the father of value investing, following his work during the 1930s. He was also the father of quality investing. Quality investing, however, is a little more difficult to describe and is not one of the generally accepted investment styles measured and analyzed by institutional investors.
Jamie Nicol, one of the founders of the Australian equities boutique Dalton Nicol Reid (DNR), has written a white paper on quality investing, including its history and the factors which have been considered as essential elements. For his firm the search for quality has also led to a strong ESG flavor to its portfolios. DNR is one of the few boutique managers which is a signatory to the UN’s Principle for Responsible Investment.
Nicol says that Benjamin Graham actually classified stocks as either ‘quality’ or ‘low quality’. Graham also observed that the greatest losses result not from buying quality at an excessively high price but, rather, from buying low quality at a price that seems like good value, Nicol says.
But most research on quality comes from management literature, and mainly from the big US Ivy League universities, rather than investment management.
In 2000, however, a professor of accounting at the University of Chicago, Joseph Piotroski, published a paper which looked at whether it was possible to improve a portfolio of value stocks by eliminating those of lowest ‘quality’. He produced a nine-point scoring system to identify quality. Piotroski has become the most celebrated academic on quality investing.
Nicol says that quality is an elusive characteristic, with a number of studies identifying different factors which support the definition.
DNR has settled on five factor headings which incorporate the Piotroski scoring system and add the ingredient of ESG. The firm also has a separate ESG fund which is offered alongside its flagship concentrated (“high conviction”) equities strategy to the institutional market.
DNR’s quality factors are:
- industry positioning – a Porter analysis is used to identify superior positioning, competitive advantage and ability to sustain returns
- earnings growth – companies are scored on return on equity (ROE), change in ROE, margin, change in margin, volatility of forecasts and EBITDA as a percentage of cashflow
- balance sheet – companies scored on net debt to equity, net debt to EBITDA and interest cover
- management score – a subjective measure based on the portfolio managers’ experience, including the company’s history of allocating capital well
- ESG score – based on the Corporate Analysis Enhanced Responsibility database and the portfolio managers’ assessment, including a key regard for tail risks that could impact valuation.
Nicol said that, as an example, petroleum giant BP would have scored poorly on ESG factors ahead of the American Gulf spill and this would have acted as a warning for international shares managers who looked at ESG factors. The stock was hammered after the spill.
The Australian market yields an investment universe of only about 60 stocks which fit DNR’s quality, liquidity and value filters. The manager chooses between 20 and 30 of these stocks for its concentrated portfolio. The value component tends to extend the cycle of expected outperformance from the quality components. Quality stocks usually hold up well in down markets but will underperform when the market gets toppy.
DNR was formed in 2001 and has tended to concentrate on the upper end of the retail market, offering SMAs to high net worth investors, however it has recently broadened its business focus to include larger super funds.
The firm is based in Brisbane, which Nicol believes offers two advantages over Sydney or Melbourne firms: it is easier to attract and retain good staff; and there is less market ‘noise’ and distractions from other service providers.