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, business model, 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 value investing, 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