Quality and value delivered steady outperformance
Our analysis showed that owning companies that are both high quality and inexpensively valued delivered the most consistent long-term outperformance for investors. As shown by the top line in Exhibit 1, the greatest relative performance advantage would have occurred at the intersection of high quality and low valuation. Owning stocks of companies that met our “high quality” and “low P/E” criteria would have resulted in cumulative excess returns of nearly 452%, or more than 499 basis points per year over the 40-year study period. The “low P/E” group of stocks shown in the bottom line of Exhibit 1 — those that were most inexpensively valued, regardless of quality — generated cumulative excess returns of nearly 357% over the 40-year time period, or an annualized outperformance of roughly 443 basis points.
This is significantly higher outperformance than would have been achieved using a quality-only metric over the same time period. The highest-quality companies, regardless of valuation, generated only a modest benefit — a cumulative outperformance of 1.8%, or an annualized outperformance of 5 basis points.
Since our study period began in 1975, coinciding with the “Nifty Fifty” valuation bubble, we decided to examine data for the time period 1980 – 2014 to assess the impact that the unwinding of the valuation bubble had on returns for the highest-quality stocks over our initial evaluation period. In fact, the effect was quite significant. In this 35-year period, a strategy focused on owning the highest-quality companies, regardless of valuation, would have resulted in cumulative excess returns of 23.7%, compared with only 1.8% for the original evaluation period (1975 – 2014), and 68.8 basis points per year as compared with 5 basis points per year for the 40-year period, reinforcing the importance of valuation as an investment consideration.
At the same time, because valuation was a significant source of value for strategies not owning the most expensive stocks during the initial five years of our analysis (1975 – 1980), the returns for the “low P/E” group and the intersection universe of high quality and low valuation were less favorable using an evaluation period starting in 1980 instead of 1975. For the period from 1980 to 2014, the returns for the “low P/E” group of stocks were a cumulative 232.1% and an annualized outperformance of 395 basis points, while the intersection universe of high quality and low valuation returned a cumulative 253.8% and 416 basis points per year.
While these are both lower than the returns for the period from 1975 to 2014, they are still substantially positive and substantiate the main conclusions of our original analysis, including the observation that the intersection universe provided the best returns. In line with this, we would argue that both quality and valuation are important drivers of long-term stock price performance.
Outperformance staying power: Another hallmark of quality and value stocks
As shown in Exhibit 2, with a few exceptions, high quality/inexpensive companies have posted impressive relative outperformance over rolling 5-year and 10-year periods. This group outperformed the broader universe over 86% of the time, when examined over 5-year rolling periods, and turned in an even more notable 93% outperformance rate over 10-year rolling periods.
Most recently, these companies have experienced a period of underperformance in contrast to the historical trend. This has coincided with central banks adopting unprecedented monetary policy measures that have injected significant liquidity into the financial system, which in turn has prompted investors into riskier market segments. We expect the market environment will normalize and longer-term trends will predominate. In our view, there is no reason to believe that the basis for the outperformance of high quality/inexpensive companies over the longer term has fundamentally changed.
In reviewing the historical performance of this group, it is also noteworthy that the magnitude of periods of relative outperformance is much greater than the periods of underperformance. This is likely due in part to the relatively lower risk profile offered by high-quality characteristics such as low financial leverage and consistent, higher returns, as well as lower valuation.
Does the quality/value screen offer insights about sectors?
We observed that financial services, utilities and communications stocks were less likely to pass the quality and value screens. This may be due to the “low leverage” requirement of our quality definition, as these sectors tend to have relatively high financial leverage. Also, many utility and communications companies had lower overall returns. Aside from this observation, no other relationships were apparent.
Persistence in quality is meaningful
This study also demonstrated that quality characteristics of companies tend to persist over time. We found that companies in either the highest- or t is far better to buy a wonderful company at a fair price
than a fair company at a wonderful price.
— Warren Buffett, 1989lowest-quality quintiles were the most likely to keep those designations over time. Even higher-quality companies in cyclical or challenging industries were less likely to see their returns diminish as often or as quickly as market observers commonly think.
As shown in Exhibit 3, on average more than half of the companies that started in the first quintile of quality were still in this quintile three years later. Furthermore, on average two-thirds of companies that started in the first quality quintile remained in one of the top two quality quintiles after three years.
t is far better to buy a wonderful company at a fair price
than a fair company at a wonderful price.
— Warren Buffett, 1989
The reverse was also true. The dearth of companies in the analysis that migrated from lower- to higher-quality quintiles over time underscores the disappointment felt by optimistic investors who predict a turnaround that fails to materialize. On average, over half of the companies starting out in the bottom-quality quintile remained in the bottom two quality quintiles after three years.
An important implication of quality persistence is that investors should focus on identifying and owning shares in higher-quality companies at the right price rather than trying to identify the rare “home run” — a company that moves from third-rate to first-rate. Those companies that do emerge do not compensate for the high proportion of those that do not.
Our study affirms the investment rationale for buying higher-quality stocks at compelling valuations. Higher-quality companies do indeed create more value than average companies in the market. However, investing in quality without regard for valuation is not a winning strategy for driving alpha over time, as valuation is a significant driver of longer-term investment performance. Owning companies that are both higher quality and inexpensively valued has been shown to be the best way to generate sustainable, long-term investment performance.
We defined quality along three dimensions: three-year average return on equity (ROE), volatility of the three-year average ROE and three-year average assets to equity. The data were standardized within each dimension to equivalent terms by calculating a z-score, or standard score, for each metric in order to create a single quality measure. The universe of companies was then broken into quintiles based on the quality score and rebalanced on a quarterly basis. Companies falling into the first quintile were defined as “high quality” companies.
Trailing price-to-earnings (P/E) ratios were used as the measure for valuation. Companies were divided into quintiles based on their raw valuation scores. Those falling into the cheapest two quintiles were considered to be “inexpensively valued” or “low P/E” companies (two quintiles were used to ensure a sufficient sample size).
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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