A qualitative approach to quality

April 6, 2023

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During times of volatility and uncertainty, quality investing can be a common buzzword among investment managers and the media alike. But what is it exactly? This commentary discusses what quality investing means and how Global Alpha incorporates its quality bias into its portfolios.

Novice investors often confuse defensive characteristics for quality, as the quality factor falls under the defensive category. However, defensive stocks are defined by their non-cyclicality, which means their financial performance isn’t significantly affected by the state of the economy. These stocks, such as household products, utilities, food suppliers and discount retailers, tend to outperform cyclicals during recessions and also on an absolute basis.

In contrast, quality investing is unrelated to market cycles or sectors. Instead, it’s defined by certain fundamental characteristics that distinguish a company from its peers. These include factors that give a business a more durable and sustainable competitive advantage, as well as profit and cash flow stability. Key variables that define the quality factor include:

  • Moat: This term, popularized by Warren Buffett, refers to the factors that allow a company to maintain its long-term competitive advantage over its peers (e.g., economies of scale, intangible assets, switching cost, etc.).
  • Business model: A durable corporate structure and business strategy can enable a company to remain nimble and competitive, unlike many Japan-based companies with bloated corporate structures operating in multiple unrelated lines of business.
  • Corporate governance: This criterion examines management strength and the quality of the rules of governance. Strong governance practices are now widely accepted within the investment community as beneficial (given the rise of ESG investing).
  • Balance sheet: A company with a quality bias tends to have a high return on equity, low and sustainable debt, low earnings growth variance and strong cash flow generation.

Quality is a well-documented source of alpha. Eugene Fama and Kenneth French, who won the 2013 Nobel prize in Economics for their three-factor model (size, value, market risk) have updated their model to include two factors related to quality: profitability and asset growth. This is backed up by other research that has also shown how profitability and stability are as useful as size, value and market risk at explaining returns.

So why don’t all managers have a quality bias? Although many studies illustrate that quality tends to outperform over long periods, there will be times when it does poorly relative to other factors. Most notably, quality companies tend to underperform in momentum-based environments wherein investors disregard fundamentals and valuation and stock winners keep on winning. The last decade has seen many momentum-driven cycles, including the COVID-19 rebound in 2020 during which tech stocks were in vogue and names like Zoom, Robinhood and Peloton were trading at multiples that implied they would become the next Apple or Microsoft.

Quality-biased fund managers can encounter several challenges in such environments, including avoiding speculative names and selling their winners too soon. Quality strategies often incorporate GARP (Growth at a Reasonable Price) even though discussions of quality as a factor do not technically address valuation. However, their bottom-up approach and consistent growth of their companies make these investment managers more aware of the cost they are paying for that growth. Quality strategies can offer superior downside protection and steadier returns than peers despite not experiencing the same highs as momentum strategies.

An example of a quality holding in our portfolios is CVS Group (CVSG LN), one of the U.K.’s largest veterinary practice operators and consolidators. The company’s complete service offering includes laboratories, surgeries and crematoria. CVS is known for hiring new graduates and providing them with training and development, creating a consistent pool of veterinarians in a talent-scarce and competitive industry.

The company satisfies most of our quality criteria, including:

  • Economies of scales as a moat: The company’s management has a strong track record of growth through disciplined M&A and sustained organic growth. With over 25% market share in the U.K. and a differentiator as a higher-end veterinary care business, CVS has comfortable pricing power, and generates steady and predictable earnings per share (EPS) and cash flow growth.
  • Balance sheet and financials: Despite its M&A activity, the company’s net debt is well below 1x earnings before interest, taxes, depreciation and amortization (EBITDA). Management’s ambitious plan to double EBITDA over the next five years is expected to bring that ratio to a manageable 1.2x EBITDA, demonstrating their intent to maintain a nimble and flexible balance sheet.
  • Corporate structure and governance: In 2022, the company made governance structure adjustments to align with the UK Corporate Governance Code, despite not being obligated to comply with the code given its AIM listing. CVS’s governance framework is clear and transparent, with board activity and accomplishments provided to investors in the company’s annual reports.

At Global Alpha, we prioritize quality names like CVS in our investment strategy. The company provides downside protection while capturing above-market rates of sustained EPS and cash flow growth, allowing us to continue to build portfolios from the ground up.

Global Alpha Capital Management Ltd.
April 6th, 2023