Quality in active equity investing

Co-Authors: Jonathan Allison, Investment Director, European Equities Dr Mark Vincent, Global Head of Equity Research

Additional contributors: Victoria MacLean Nick Robinson James Thom April 2021 Virgilio Aquino 02 of 20 Quality in active equity investing Quality in active equity investing 03 of 20

About active equities at Contents Aberdeen Standard Investments Executive summary 04

We believe that deep fundamental research into companies, combined Part I: with team debate and rigorous stock selection, is the key to driving better investment returns for clients. Our stock-picking process is truly Why invest in quality companies? 07 bottom-up. Our approach to equity investing is underpinned by three Digging deeper: core investment beliefs: a behavioral explanation 10 • Fundamental research delivers insights that we can use to exploit market inefficiencies. In our view, company fundamentals ultimately Part II: drive share prices but they are often valued inefficiently over the Five fundamentals of quality 12 short term. Part III: • ESG assessment and corporate engagement enhance returns. We place constructive engagement and environmental, social and A practical guide to quality 16 governance (ESG) considerations at the heart of company research, ensuring we are responsible stewards of our clients’ assets. We believe that this approach can mitigate risks and enhance returns for our clients, as companies with robust ESG practices tend to enjoy long-term financial benefits.

• Disciplined, active investment can deliver superior outcomes for clients. We aim to build high-conviction portfolios where our Our Thinking: stock-specific insights drive performance, giving our clients access to our best investment ideas. Thought Leadership

To make full use of our considerable research capability, our equity Our thought-leadership papers deliver thought-provoking teams use a common investment language and research framework analysis of key investment themes. Through focused and that structures how we express our thinking about companies. unique insights into topical issues, we aim to provide Combining research insights with rigorous peer review allows our fund investors with a deeper understanding of the challenges and managers to effectively assess the investment potential of companies. opportunities within global investment markets.

By prioritizing particular insights, we can drive distinct client outcomes. The market’s inability to price quality correctly is one of the most common inefficiencies that we see in equity investing. Evaluating the quality of business for every stock we research helps us to ensure that we have properly understood its opportunities and risks. In our Long-Term Quality strategies, we choose to invest only in high-quality companies, aiming to exploit this pricing inefficiency. 04 of 20 Quality in active equity investing Quality in active equity investing 05 of 20

Executive summary

This paper focuses specifically on the quality phenomenon. We look at why investing in quality companies has historically been a “If the business does well, successful approach for investors. At Aberdeen Standard the stock eventually follows.” Investments, our analysts carry out rigorous fundamental research and engage proactively with company management teams in their Warren Buffett search for quality. Much of this process is based on what we call the “five fundamentals of quality”. In our view, evaluating these factors – industry, , financials, management and ESG issues – is essential to active quality investing. These characteristics take on even more gravity in the post-Covid environment. Part II of the paper discusses them in detail. Once investors have made their initial analysis, they must also judge the right price to pay for quality. And they must understand how the characteristics of quality companies affect their overall portfolio. To date, the market has systematically undervalued the persistence of returns from quality companies. And so to understand quality in the context of equity investing, investors must use fundamental analysis to define, measure and manage it. By doing so, active investors could have the opportunity to add value. 06 of 20 Quality in active equity investing Quality in active equity investing 07 of 20

Part I: Why invest in quality companies?

Quality investing – buying and holding a portfolio of high-quality companies – has proved to be a highly effective strategy in many markets over the past few decades. What are the reasons for this? Past returns are no guide to the future, but are there reasons to believe that investing in quality will remain a compelling approach? After addressing this, we then turn to a deeper analysis of how quality is defined, arguing that past approaches and definitions of quality, while powerful, can be augmented to provide deeper and more nuanced insight into what makes a quality company. 08 of 20 Quality in active equity investing Quality in active equity investing 09 of 20

Powered by persistent returns unique product feature, a recipe, a brand, a network effect or a lack Lessons from management consulting A company with a deep and wide economic moat is well protected We think there are two key avenues for explaining the performance of competitors. Once in place, competitive advantages tend to have A purely quantitative analysis is by no means the only approach to from competition on all sides. This drives sustainable value creation, of quality. The first relates to the persistency of returns and is quite more staying power than the market thinks. By misjudging this quality. In fact, it leaves significant stones unturned. which is the essence of quality. The building blocks can include intuitive to understand. The essential point is that companies that durability, investors might misprice consistent and Before the arrival of quantitative investors, management consultants pricing power, cost competitiveness, superior routes to market, deliver above-average returns due to their durable business model persistent returns. and business school academics developed tools to help businesses better innovation and powerful brands. The natural outcome of this and strong competitive position tend to see those returns persist for This brings us to the second avenue for explaining the performance understand their competitive advantage. They used more qualitative is that investors should look for the following: longer than the market expects. High short-term returns might make of quality, one that comes from the area of behavioral psychology. frameworks to understand the strength of a business. And they • companies with weak competitors among existing firms these companies already more expensive than average. The behavioral biases of the ‘average’ investor (for example the provided important insights that backward-looking measures of Nevertheless, the market does not extrapolate enough for the • high barriers of entry for new entrants to overcome short-term time horizon discussed above) can drive performance company accounts cannot capture. Bruce Henderson’s Growth Share persistency of these returns. As they are delivered year after year, patterns that create opportunities for more rational investors. We Matrix, created in 1968, is an example of this. Henderson was the • multiple customers, and suppliers with limited bargaining power the market is forced to re-appraise. As a consequence, the stock explore this topic further in A Behavioral Explanation of Quality on founder of the Boston Consulting Group and advocated separating outperforms. • limited threat from substitute products page 9. the ‘stars’ from the ‘dogs’ on the basis of their growth and market Is there any systematic evidence to support this theory? A study by share. It is important to note that these economic moats are not static –this Accounting for quality Credit Suisse’s HOLT team provides a useful perspective.1 The study analysis is not something that can be done once and then forgotten. Interestingly, there is no single widely accepted definition of quality. Perhaps the best-known example of the consulting approach is used their proprietary measure of cash-flow return on investment Analysts need to regularly monitor companies’ strengths and quality. There are, however, common strands that we can trace through Michael Porter’s 1979 ‘Five Forces Framework’ for analyzing a (CFROI®), dividing companies into quintiles based on return, Disruption and shifts in competitive dynamics are always a history to the quantitative or passive approaches of today. company’s competitive position. Porter argued that quality and found that companies with the highest returns saw these fade possibility. Looking at a company using only a rear-view mirror businesses are better able to fend off competitive pressures because towards the average over time. Crucially, however, the fade rate was Benjamin Graham, often seen as the godfather of , means that by the time a problem shows up in its numbers, it could they have strong economic moats. slow - and slower than for companies with lower initial returns. Even was an early champion of focusing on quality. In Securities Analysis, be too late from an investment perspective. Taking an active a decade after they were first identified, returns for these written with David Dodd in 1933, he set out seven investment approach to monitoring means they are more likely to identify any highest-return companies remained above average. criteria. Alongside two measures of value, he included five measures changes at an early stage. of quality, one of them being “adequate enterprise size, as insulation Decay of returns over time: regression towards the mean against the vicissitudes of the economy”. His measures are consistent for CFROI® with many modern definitions of quality: profitability, earnings CFROI vs Global Median stability, balance-sheet strength and a durable business model. 15 Since then, three seminal academic papers have shaped the quantitative approach to quality. Two of them (by Sloan and Piotroski 10 respectively) were written by professors of accounting. They argued that it was important to focus not just on the magnitude of earnings 5 but also on their quality and on the financial strength Figure 4: Five competitive forces that shape strategy of companies.2 0 Over the past decade, investors’ interest in alternative risk premia Threat of has grown. Academics, index providers and quantitative investors new entrants -5 have all set off to find the winning formula for quality. One of the most influential studies was The Other Side of Value: the Gross Profitability Premium (2012) by Robert Novy-Marx, a professor of -10 0 1 2 3 4 5 6 7 8 9 10 business administration. He found that despite their higher Year valuations, investments in profitable firms yielded better returns. (-10, -6) (-6, -2) (-2, 2) (2, 6) (6, 10) (10, 14) These papers and other similar studies have created a long list of Bargaining power Source: Credit Suisse HOLT. Note: Global companies excluding rhe Bargaining power potential quality definitions. The common element, however, is the financial services and utilities sectors no size limit. Data reflects fiscal of suppliers of buying years; updated as of 26 October 2020. For illustrative purposes only. focus on accounting ratios and quantitative techniques based on the Rivalry among past performance of companies. existing firms The reason for this effect is not hard to find. Companies tend to make consistent high returns because something about their business model has enabled them to do so. This could be a

Threat of substitutes

1 Corresponding citation at the bottom of the page should be: Bryant Matthews and David. A Holland, Credit Suisse, “Wealth Creation Principles: The Anatomy of CFROI® Fade: The Persistence of Profitability Margin and Asset Turns,” November 2015. Source: Michael E Porter, Competitive Strategy (New York,1980). For illustrative purposes only. 2 Joseph Piotroski, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers (2000). 10 of 20 Quality in active equity investing Quality in active equity investing 11 of 20

Digging deeper: a behavioral explanation

From a behavioral perspective, the premium Lottery bias. When it comes to lotteries, people have a tendency to Managing our biases … and profiting from the biases of others return from investing in higher-quality companies focus on the size of the reward. The larger the jackpot, the more we To prevent our biases adversely affecting the decisions we make, we are willing to ignore the high probability of losing. Alok Kumariii studied must understand them. We cannot remove them, but we can build is something of a puzzle. After all, loss aversion is whether this behavior applies to investors in his paper: Who gambles in more systematic processes to overcome their negative influences. arguably the most well-known bias displayed by the stock market? He found that “people’s attitudes toward gambling With this understanding comes the potential to profit from the investors. Indeed, identifying loss aversion helped are reflected in their stock investment choices”. This gambling biases of others. behavior may lead investors to over-pay for stocks with lottery-like By adopting a systematic approach to quality, investors can take the Daniel Kahneman win the Nobel Prize in payoffs: typically lower-quality stocks that may ultimately disappoint. other side of the trade to those succumbing to these biases. Economics. So we might expect investors to Present bias. Human beings have a tendency to favour near-term Investors in quality companies focus on long-term potential, not overpay for securities with perceived stability and rewards. Quality stocks are more likely to deliver a long-term payoff near-term rewards, and on predictable earnings, not volatile share downside protection, accepting lower returns as a through the compounding of high returns over time. By contrast, prices. In this way, a quality approach has the potential to profit from lower-quality stocks may provide the possibility of a higher near-term the irrational behavior of the average investor. consequence. payoff. Present bias means we are likely to overvalue the potential A holistic definition of quality short-term benefits of low-quality companies – with their option-like In practice, however, the reverse has been true, We have considered two reasons for the historic strong stock-price payoff – and undervalue the long-term benefits of quality companies. with quality stocks outperforming despite their performance of quality companies, and while past performance is no lower volatility. Recency bias. Humans also tend to attach more importance to guide to the future, there is no reason to think that these no recent events. Investors might focus on earnings announcements, longer hold. There are six behavioral biases that may contribute to corporate news and the latest economic data. This can lead them to We have also looked at historic approaches to quality – this outperformance. undervalue long-term profitability. the quantitative or accounting approach and the business model or Overconfidence bias I: investors. Among drivers in the US, Incentives. As always, incentives matter. Some professional investors management consulting approach. Both have their strengths, but we 93% claim to be better than average – a statistical improbability.ii are incentivised to generate strong short-term performance. They would argue that both also have their limitations. Investors need to Investors can have a similarly exaggerated belief in their own may hope to raise a large amount of assets – or perhaps rescue their define quality in a way that allows them to both explain and measure abilities. They may be prone to believe that their expertise will be career. Others profit from performance fees based on one- or it. Quantitative approaches rely on backward-looking data. They do best rewarded by selecting riskier stocks: companies with higher three-year returns. These investors may overpay for volatile stocks not seek to understand what it is about the business that has driven leverage, more variable earnings and greater earnings upside with the potential for the highest near-term payoffs. returns. Meanwhile, qualitative frameworks help explain quality but potential. This focus can leave higher-quality, more stable companies do not measure it, and they are not inherently focused on what undervalued, thereby offering higher returns. “Deeper thinking about might change in the future. Overconfidence bias II: companies. Company management teams Nor is a simple combination of quantitative measures and qualitative are also prone to overconfidence. They may, for instance, competition is a more powerful tools sufficient. Companies are managed by people – with all their overestimate future growth, guiding the market or even booking strengths and weaknesses. Assessing the quality of the management profits too bullishly – and investors may fall for these projections. way to achieve genuine team – and the board that oversees their activities – is also vital. When the actual earnings fail to match expectations, the stock price Furthermore, analysis needs to be forward-looking, with the aim of may fall. Stronger management teams, by contrast, are less prone to investment success than the understanding whether the strong returns of the past will persist overconfidence and create fewer negative surprises even though the financial projections and trend into the future. Investors need a dynamic and future-focused story may not sound as exciting on the surface. approach to quality, one that is based on deep extrapolation that dominates fundamental research. Within Active Equities at Aberdeen Standard Investments, we focus today’s investment analysis.” on five fundamentals of quality augmented by quantitative screening, which allows active investors to define and measure Michael Porter quality in a holistic way. The Five Competitive Forces that Shape Strategy 12 of 20 Quality in active equity investing Quality in active equity investing 13 of 20

Part II: Five fundamentals industry of quality 1

At Aberdeen Standard Investments, Five fundamentals of quality we believe that while equity markets 1. Industry 2 are broadly efficient, we can use deep, Investors must evaluate the industry that a company operates in from many angles. fundamental analysis of companies to Understanding the potential for growth business identify and exploit specific inefficiencies. requires them to assess the maturity of the industry and the competitive environment. Rigorous research is at the centre of our active equities business. model Through it, we believe we [or alternately, we have been able to] can For example, investors need to ask whether there are opportunities generate outperformance from idiosyncratic, stock-specific factors. to allocate capital in ways that add value. Their forecasts must take account of the cyclicality of the business. One of the inefficiencies we see repeatedly is the market’s inability to Regulations, both local and global, can affect returns. In addition, price quality correctly and the persistency of returns. Evaluating the investors need to explore the potential of companies to disrupt the quality of every stock we research helps us to ensure that we have status quo – or to be left behind by the disruption of others. properly understood its opportunities and risks. In our long-term quality strategies we choose to invest only in high-quality companies, Example: Nemetschek is a German software vendor for architects, aiming to exploit this pricing inefficiency. engineers and builders. This innovative company is helping to drive two profound changes in its end markets. First, it has led a shift to We have developed a framework to help us evaluate the different financials digital design and construction modelling within the building dimensions of quality. We focus on five factors: industry, which has accelerated over the last few years. 3 • Industry Nemetschek’s software enables its customers, who are contractors • Business model in major building and infrastructure projects, to improve efficiency, control costs and increase levels of collaboration. Second, the • Financials industry is also benefiting from shifts in regulation. In many • Management countries around the world, the use of building information modelling software is now compulsory in new government building • Environmental, social and governance (ESG) considerations. projects. We expect both these factors to provide a strong tailwind to By blending our analysis of these factors, we aim to arrive at a full industry growth for many years. understanding of a company’s quality. Flipside: Investors should be more wary of industries where products are likely to be made obsolete by shifting customer management preferences. These include sectors like fashion or those where competitive pressures are intense, such as airlines. Some companies, for example those that produce basic materials, are also vulnerable when there are limited opportunities for product differentiation. While these industries certainly produce investment opportunities from time to time, a quality approach will put a higher burden of proof on ensuring that the returns on offer are sustainable. 5 environmental, social 4 and governance (ESG) 14 of 20 Quality in active equity investing Quality in active equity investing 15 of 20

2. Business model and moat It is also important to understand how the business is financed by Management teams that discuss these issues openly with fund disclosure to labor relations. These are important issues for If a company earns a return above its cost of analyzing the balance sheet. What are the firm’s liabilities? Is the managers – and answer these key questions – are, in our experience, both operational performance and business reputation. capital, will this persist? Answering this question capital structure sustainable? The balance sheet reveals vital the ones that are most likely to avoid corporate catastrophe. Corporate culture is notoriously difficult to define and measure, but requires an understanding of a company’s position information about the capital intensity of the business. Management teams that can respond to changes in the business it is not an undertaking that should be skipped. Meaningful analysis in its . This means assessing its Analysts must assess whether or not the company will be able to landscape are best placed to create value for requires deep knowledge of the company and engagement with competitive strengths and weaknesses at every withstand any shocks that hit its industry or the wider economy. This all stakeholders. management over a prolonged period. stage of its activities. Quality increases with the ability to weather challenging economic environments is particularly Example: DSV Panalpina is a Danish transport and logistics provider. Example: We have been visiting Arezzo, a Brazilian shoemaker, for a size of its ‘economic moat’ so analysts should seek high barriers to important for companies operating in cyclical industries with more It provides a range of transportation services and solutions: covering number of years. Initially, the CEO showed a tendency to focus on entry that prevent competitors eating into outsized returns. unpredictable or volatile revenue streams. Stronger companies may air, sea and road transportation plus warehousing and logistics short-term profit generation rather than the longer-term drivers of be in a position to benefit from the stresses of their weaker Example: Over the past 20 years, the semiconductor market has services from over 1,500 offices around the world. A good shareholder value. We actively engaged with management to set out competitors. grown at an average of 5% per annum. Still, not all IT companies have management team is a critical ingredient in the success of such a the expectations of shareholders. Over time, the founder moved benefited. Investors focused on high-volume hardware have seen Flipside: Investors should be wary of companies with high debt levels complex business; DSV’s team has a long and impressive record of positively from a focus on the current wealth of his family to putting competitive advantage come and go. From PCs in the 1990s to or poorly managed financial risks, such as exposures to commodity successfully integrating new businesses and improving returns. structures in place to ensure his legacy. As the company moved from smartphones in the noughties and the smart speakers of today, all prices, foreign currencies or changes in interest rates. Commodity Companies must also understand the key risks facing their business. being family-controlled to having a broader and more balanced have been commoditised. However, quality investors have had some producers, for example, need sufficient balance-sheet strength to Close to the top of the list for a logistics company is the threat of shareholder base, our conversations on governance have, we believe, opportunities, such as the providers of manufacturing equipment to ride through the inevitable cycles in commodity prices. North Sea oil failure to its critical IT infrastructure. DSV’s team has invested heavily helped shape this agenda. these hardware companies. ASML is a prime example, a leading and gas company Enquest, listed in London and Stockholm, provided to combat this risk. Flipside: Poor governance is a red flag for analysts. Investors need to manufacturer of lithography machines used in printing circuitry onto a case study of what can go wrong when this principle is ignored. The Flipside: In contrast, competitor Maersk suffered from a massive know that company management is acting in the best interest of all semiconductor chips. Its leading market share – and in some cases company faced a perfect storm in 2014–15. A number of major cyber-attack in 2017 that severely impaired its ability to do business. shareholders. In addition, analysts should be wary of companies that monopolistic position – in these lithography machines gives it projects were unfortunately beset by operational delays, which This incident is estimated to have cost the company around $300 show little regard to their environment or society at large. These significant pricing power over its customers, even as their own created a lack of cashflow. When the oil price fell from $100 in June million, as well as causing significant reputational damage. managements risk reputational damage, regulatory fines and an pricing power has eroded. This Dutch company invests more in 2014 to less than $40 in August 2015, unmotivated workforce: major impediments to long-term research and development than any of its key competitors to Enquest ran into financial difficulty. The company was forced to raise Investors should also be wary of managements that make value creation. maintain its technological lead. It has also benefited from the additional equity and restructure its debt. acquisitions and expand aggressively outside their core business. research and development efforts of its main customers: Intel, Some management teams can be too focused on their short-term For example, Indian IT services provider Vakrangee seemed well 4. Management Samsung and TSMC. They have invested more than €5 billion in share-price performance, or accounting earnings, rather than positioned to benefit from strong international demand for the Analysts must judge the ability of management ASML technology over the years to maintain their own competitive long-term measures of value creation. Others suffer from hubris country’s expertise in outsourced IT solutions. However, the stock’s teams to allocate capital effectively. advantages. after a period of success. For example, after growing rapidly in its promoter (major owner and founder) had played a key role in several Their projects need to add economic value domestic market, Australian insurer QBE embarked on a string of businesses that had become penny stocks or defaulted on their Flipside: Analysts should ask if margins are too high and therefore and drive future cash generation. Does the overseas acquisitions that ultimately destroyed value. debts. Vakrangee’s share price collapsed in early 2018 after unsustainable at a given company. Investors should be wary of management in question have a history of allegations of stock-price manipulation. companies that are overly dependent on external factors beyond spotting and delivering value-creating 5. ESG Analysis their control, with no economic moat. The global financial crisis opportunities, or does it squander capital on Companies that take a comprehensive and The next step? provided many examples of companies that failed because of their projects outside its core expertise? How the team has managed its serious approach to ESG issues can minimise Our five-factor framework provides a holistic definition of quality. reliance on short-term funding from the interbank market. Accessing business through tough times also gives important clues about the the associated risks. With investors Our investors combine this analysis with traditional quantitative this source of finance required no particular competitive advantage, future, providing reassurance or provoking concern. scrutinizing these risks more closely, measures to assess the quality of companies. But this ranking is not and when this source dried up, many of these companies failed. companies that adopt best practice are likely sufficient to make an investment decision. Investors must also It is also important to consider how management is incentivised. to be rewarded with a higher . consider other factors such as valuation, the state of the economic 3. Financial strength What are the key performance indicators for senior team members? cycle and the potential for quality to change over time. Only then can Any assessment of a company’s future should be informed by Are these aligned with shareholder interests? These are important It is not just about perusing some disclosure they take a view on whether there is financial upside in holding a assessing its historic cashflow generation. governance issues. Investors need to consider whether management metrics or looking at quality stock. We address these issues in the final section, How capital-intensive or margin-dilutive is properly motivated to manage risk in the business, as well as to a score from a data provider. Investors must understand the culture A Practical Guide to Quality. might future growth be? Analysts must drive growth. The collapse of Enron, which was caused by a of a company: poor culture leads to poor risk management. This can understand if a company can fund its growth single-minded pursuit of steady earnings growth at the expense of affect companies in many ways, from financial through internal cash generation or existing integrity, provides an extreme example of how the wrong incentives reserves, or whether it will need to source can lead to poor management practices. funding externally, thereby increasing risk. Different risks apply to different companies and industries. The quantitative analysis of accounting metrics How do management identify and prioritise their key risks? discussed in Part 1 is helpful here and can be a shortcut to screening How often do they review them? How do they mitigate those risks? for and identifying companies with strong financial attributes. These Investors also need to be clear on where responsibility for managing need to be interpreted relative to the company’s industry and risk lies: with the board or with the executive team? specific circumstances, however. We also need a basic understanding of what it is about the business that generates its returns. 16 of 20 Quality in active equity investing Quality in active equity investing 17 of 20

Part III: Quality and the cycle Quality from an ESG perspective The intrinsic nature of quality companies mean that their stocks tend Good governance, and robust management of environmental and to outperform during market downturns. Investors value strong social risks are behavious often evident in quality companies. A practical guide to quality balance sheets, more predictable earnings and sustainable business However, analysis of ESG risks should not just be a box-ticking models when investment risk increases – particularly exercise in an investment process, particularly in the context of a during recessions. quality approach. It can add meaningful value to the decision-making The opposite also applies: when investors believe that risk is process. reduced, they are more willing to invest in riskier stocks such as Today, it seems that every investor says they integrate ESG factors those of smaller companies or companies operating in more into their investment process. And so they should: these risks Quality companies offer the potential of a return The three single factors have different characteristics with respect to economically sensitive or cyclical sectors. Therefore, quality are financially material. In arguably the highest-profile example, the stocks typically lag as the market recovers from a recession. environmental degradation caused by BP’s Deepwater Horizon oil premium for long-term investors. Analysts need a quality and valuation, neatly bringing together the consideration of quality and valuation in the investment process: Since quality stocks have outperformed through past cycles, spill cost the company U$65 billion in 2018. holistic perspective to successfully define and the outperformance during down markets has generally • Return on equity (ROE) is a quality factor. It is a measure of how A number of agencies offer investors the opportunity to subscribe to exceeded the underperformance in strong markets, measure quality. However, identifying quality is successfully a business uses equity to produce profits, applicable their ESG ratings. However, these off-the-shelf measures differ so the net effect has been positive, supporting the across different industry sectors. It does not incorporate current significantly. Aggregate Confusion: The Divergence of ESG Ratings by Berg, not sufficient for investment success. In practice, quality approach. price, so does not provide a measure of value. Koelbel and Rigobon,iv published in May 2020, identifies three sources investors must consider the right price to pay. Investors need to understand these different sensitivities for this divergence: • Dividend yield is a value factor. It provides no indication To assess and monitor quality and then determine the appropriate when assessing the risk of their overall portfolio. In general, of quality. • Scope: different rating agencies include different factors in valuation, investors need to actively engage with companies. quality stocks can bring diversification benefits alongside more their ratings. In practice, it is hard to do this effectively without extensive • Free cashflow (FCF) yield is a quality-value factor. It incorporates economically sensitive investments. • Measurement: they measure these factors in different ways. investment experience and deep resources. the stock price (and therefore value) along with the amount of free Quality stocks have also benefited from a longer-term cycle: cash a company produces (a measure of quality). Putting a value on quality the multi-decade decline in global interest rates. This trend has • Weight: they apply different weights to factors when aggregating Quality investing is not simply the opposite of value investing. The study measured each factor’s information ratio (IR), a measure of provided a tailwind for bond investors, generally pushing prices up them into an overall score. If it were, we would not find companies like PepsiCo in both the MSCI the risk-adjusted return of a portfolio. An IR over 0.5 is generally and yields down. This same force has boosted the performance of In addition, Berg, Koelbel and Rigobon identify a ‘rater effect’: World Quality Index and the MSCI World Value Index. Analysts must deemed to be a good result. The discrete measures of ROE and FCF bond-like equities: those offering more predictable dividend yields. “The rating agencies’ assessment in individual categories seems to be consider whether there is value in a stock alongside its quality. yield both delivered good IRs, which supports the existence of quality Some quality companies fall into this category: their high-returning, influenced by their view of the analysed company as a whole”. In short, Investors seeking excess returns must find securities whose quality and value factors. However, it was a combination of the two that highly cash-generative business models put them these ratings provide some value, but analysts must take their own is not fully reflected in its price. delivered the best IR overall: the approach that incorporates in a position where they can pay sustainable dividends. view on the three factors. There is no substitute for ESG analysis that A research collaboration between the Active Equities team at measures of both quality and valuation. is grounded on a deep fundamental knowledge of a company from the Aberdeen Standard Investments and our Quantitative Investment This insight makes intuitive sense. Buying ‘quality’ companies with no perspective of a seasoned investor. This analysis must include a Strategies team demonstrated this principle in the quantitative space regard to valuation is a risky strategy. This quality may already be holistic view of how ESG factors affect the business. by analyzing the interaction of quality and value. understood and fully priced by the market. Buying ‘value’ stocks that Nor is ESG analysis just about identifying risks. Companies that The study back-tested four factors over a period of 30 years: are cheap for a good reason is also unlikely to be a winning strategy. address their ESG issues can find opportunities to cut costs or grow free cashflow yield (FCF); return on equity (ROE); a combination Instead, investors should seek companies whose quality is not yet “Since quality stocks have revenues. For example, Kingspan, the building-insulation specialist, is of the two; and dividend yield (DY).3 This allowed us to assess appreciated by the market: where strong returns are expected to 75% of the way towards a net-zero energy goal whereby it plans to the drivers of historic outperformance from a purely persist for longer than the consensus view because of the company’s outperformed through past match 100% of its operational energy with renewable energy. This has quantitative perspective. competitive advantage or economic moat. already led to a 27% reduction in energy intensity, a six-fold reduction cycles, the outperformance in carbon intensity and a 35% reduction in energy costs. Investors need a forward-looking view of how ESG issues will affect during down markets has the prospects of the company. Yet off-the-shelf ratings only provide a generally exceeded the backward-looking point-in-time snapshot. Analysts need to engage with management to understand their strategy. Through engagement, underperformance in strong investors can gain the information they need to make a decision. In particular, meetings with management are necessary to provide a markets, so the net effect has more informed view on governance issues. This is a critical component of managing an active quality portfolio. Fund managers have a duty to been positive, supporting the act in the best interests of their clients. This duty extends beyond quality approach.” managing short-term financial risks and returns: responsible investors must integrate ESG analysis into their investment process to deliver better outcomes over the long term.

3 The study ranked the global universe of stocks as represented by the Wilshire 5000 by each factor, buying the quintile by each factor, buying the quintile with most exposure to the factor and selling short the quintile with lowest exposure. This model portfolio was rebalanced on a monthly basis. 18 of 20 Quality in active equity investing Quality in active equity investing 19 of 20

Summary By blending our analysis of these factors, we aim to arrive at a IMPORTANT INFORMATION Why should investors in quality companies expect higher returns? holistic understanding of a company’s quality. Companies mentioned throughout this material were selected for illustrative purposes only to demonstrate the investment management How can we define and measure quality? What practical steps can Investors must also judge the right price to pay for this quality. They style described herein and not as an investment recommendation or indication of future performance. fund managers take to build a portfolio with the potential for more should seek companies whose quality is not yet appreciated by the predictable returns over the long term? Diversification does not ensure a profit or protect against a loss in a declining market. market: where strong returns are expected to persist for longer than The average investor has consistently underestimated the the consensus view. Important information for all audiences: Aberdeen Standard Investments (ASI) offers a variety of products and services intended solely for persistence of returns from quality companies. They focus on investors from certain countries or regions. Your country of legal residence will determine the products or services that are available to you. Quality has many dimensions. It requires judgement and skill based near-term rewards, not long-term potential; they bet on volatile Nothing in this document should be considered a solicitation or offering for sale of any investment product, service, or financial instrument to on extensive investment experience and deep resources. This share prices, not predictable earnings. This leaves scope for investors any person in any jurisdiction where such solicitation or offer would be unlawful. creates the potential for long-term investors to unlock in quality stocks to take the other side of the trade. the above-market returns that quality investing has The information contained herein is intended to be of general interest only and does not constitute legal or tax advice. ASI does not warrant Investors need to undertake a comprehensive analysis of the historically achieved. the accuracy, adequacy or completeness of the information and materials contained in this document and expressly disclaims liability for fundamentals of a business to understand why a company makes errors or omissions in such information and materials. ASI reserves the right to make changes and corrections to its opinions expressed in strong financial returns. 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ESG

i The five measures of quality set out in Securities Analysis (1933) are: • “adequate” enterprise size, as insulation against the “vicissitudes” of the economy • strong financial condition, measured by current ratios that exceed two and net current assets that exceed long-term strength • earnings stability, measured by 10 consecutive years of positive earnings • a dividend record of uninterrupted payments for at least 20 years earnings per share growth of at least one third over the last 10 years. ii Ola Svenson (1981), Are We Less Risky and More Skillful than Our Fellow Drivers?, Acta Psychologica, 47, 143–51. Note that it is theoretically possible for 93% to be above average, if the mean is calculated and the data is heavily skewed by a small group of terrible drivers (such as the 91-year old father and 17-year old son of one of us). iii Alok Kumar (2008), Who gambles in the stock market? Journal of Finance, 64, 1889-1933 iv Florian Berg, Julien F. Kolbel, and Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings,” May 17, 2020. Visit us online aberdeenstandard.us

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