A different view on ‘quality’ investing

Dr. Ian Mortimer and Matthew Page, co-managers of the newly Elite Rated Guinness Global Equity Income fund, give a different take on ‘quality’ companies and their investment process.

“The discipline of looking for companies at historic low valuations and consistently high return on capital is one that has served us well over the past six years. It doesn’t work every time, but buying a high quality company at a historic low valuation will always be preferable to us to buying a low quality company at a ‘cheap’ valuation.”

Rotation from quality to value?

“Since September 2016, we have seen a significant sector rotation out of defensive industries, such as consumer staples and utilities, into cyclical industries, such as industrials and commodities. This was subsequently accelerated by the election of Donald Trump. Some have characterised this rotation as a shift from ‘quality’ into ‘value’, but we do not see it in these terms.”

Redefining ‘quality’

“First, we do not see utilities as quality companies. They earn a low return on capital, with high leverage, and without much opportunity for growth. Consequently we have never owned one in our portfolio.

“Instead, ‘quality’ for us means three things: consistently high return on capital, a strong balance sheet and the ability to reinvest for growth at a high return on capital.

“These three elements are an incredibly powerful combination of characteristics, yet they are still insufficient for us to add a company into our portfolio. We also want to see value. It is therefore this combination of quality characteristics and value that we look for.

“Our definition of quality means we are not limited to defensive industries such as consumer staples, healthcare and utilities. We find plenty of companies in more cyclical sectors that have generated consistently high returns on capital (so-called ‘best of breed’ companies), and this has been where we have found value.

“As a result of this process our portfolio has weathered the sharp sector rotation relatively well. How this will play out in 2017, however, is very hard to predict.”

Political risk and periods of fear

“Political risk certainly appears to have increased, with various European elections this year opening up the possibility for more sharp shocks to equity markets. It remains to be seen what the long-term impact of President Trump will be on equity markets: will a domestic stimulus offset the threat of trade wars with China? Will higher bond yields drive flows out of bonds and into equities, or will an unexpected shock drive bond yields lower in a search for a safe haven?

“We do not attempt to predict the future, but we feel safe in the knowledge that a focus on our definition of quality equities should provide some downside protection during periods of fear. At the same time, ensuring we buy these quality companies when their valuations are cheap should allow us to participate in most of the upside. This approach has served us well over the last six years, and should provide some stability to portfolios in what could turn out to be a bumpy 2017.”

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.