• HOME
  • INVESTMENTS
    • Equities >
      • Australia All Cap
      • Australia Small Cap Income
      • Global Mobility
      • Global High Conviction
    • Property >
      • Listed Property
      • TAMIM Property
    • Income >
      • Credit
  • INSIGHTS
    • Insights
    • Weekly Reading Lists
  • ABOUT
  • CONTACT
Tamim Asset Management
  • HOME
  • INVESTMENTS
    • Equities >
      • Australia All Cap
      • Australia Small Cap Income
      • Global Mobility
      • Global High Conviction
    • Property >
      • Listed Property
      • TAMIM Property
    • Income >
      • Credit
  • INSIGHTS
    • Insights
    • Weekly Reading Lists
  • ABOUT
  • CONTACT

Market Insights

Good Companies Not Always Good Investments

24/7/2019

0 Comments

 
This week we present a piece by Joey Mui, from Merlon Capital Partners who power the TAMIM Australian Equity Income IMA, examining why good companies do not always necessarily make good investments.
In this paper we consider the merits of systematically investing in “high quality” companies. We conclude that:
​
  • Not all traditional “quality” factors have outperformed over a full market cycle, with the performance of both “high growth/return” and “low volatility” stocks mixed. That said, certain “quality factors” have outperformed since the global financial crisis
  • Performance of certain quality factors have coincided with falling interest rates, a trend unlikely to persist indefinitely and at risk of retracing over longer time horizons.
  • Traditional quality factors are currently expensive, with baskets of “quality” stocks trading at historically high earnings premiums to the broader market

At Merlon, we do not “screen” based on “quality”. In a subsequent paper, we will outline how Merlon’s assessment of quality impacts our view of sustainable free cash flow and analyst conviction, which in turn drives investment decisions.
Picture
The pursuit of quality

Investing in “quality” companies has been a commonly cited phrase in the investing community over the past few decades. There is no better person to encapsulate this transition from traditional “cigar-butt” value investing to a preference for quality, than Warren Buffett who stated “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. We would note however, that this shift is somewhat driven by limited value opportunities relative to Berkshire’s meaningful scale.

A key question remains: what distinguishes a “quality” company from its more average peers? Anecdotes we have often heard include
  • High quality, shareholder aligned management with proven track record
  • Dominant market positions and strong barriers to entry
  • High return on capital and attractive reinvestment opportunities
  • Low earnings and stock volatility
  • Stable and growing earnings
  • Strong, defensive balance sheet

​We agree that these are desirable attributes for a company to have. It would also not be difficult to build a portfolio of companies with these characteristics (as subjectively, most companies have a few).

However, as investors searching for mispriced businesses it is more important to consider the appropriate premium to pay for “high quality” attributes. If these “quality factors” are not systematically mispriced, owning “high quality” companies will not contribute to superior long- term returns.
Post-financial crisis “quality” investing

The pervasive market view over the past 10 years has been the outperformance of companies with high quality attributes and strong growth. In the US, we have seen this trend encapsulated by the FAANGs (Facebook, Apple, Amazon, Netflix, Google). Closer to home, we have seen multiples expand above historical levels for companies that  are

  1. High growth, high return on capital*: Companies that are growing quickly and reinvesting profits into further growth at a high return-on-capital. Represented largely by globally exposed healthcare, online digital platforms, technology and semi-regulated
  2. Defensive, low volatility**: Companies considered “safe” due to low earnings risk, stock volatility and historical market sensitivity. Largely composed of stocks in the healthcare, infrastructure, real estate investment trusts (REITs), consumer staples and bank

​We agree that stocks in the defensive, low volatility basket have outperformed since the global financial crisis in 2008/09 (Figure 2).
Picture
​Using an equally weighted index, the average “high growth/return” stock however has underperformed over the same period, contrary to general views (Figure 3). We highlight that because the general market looks at the market cap-weighted index, the outperformance by a small number of large cap “high growth/return” stocks have skewed the misperception that the “growth/return” factor has outperformed in the ASX100 over the past ten years.
Picture
Increasing overvaluation

“Pursuing quality regardless of price is, in my opinion, one of the riskiest – rather than safest – of investment approaches” – Howard  Marks

Historic performance is one thing but as forward-looking investors, we remain cautious on “high growth/return” and “low volatility” as proxies for quality investing, given the valuation premium ascribed to these stocks is high in a historic context. This highlights the share price gains that have not been supported by underlying  earnings.
Picture
Picture
In the post-GFC environment characterised by low interest rates, inflation and macroeconomic growth, investors have clustered within these “quality” stocks.
Low interest rates a contributing factor

​We would argue that the ongoing reduction in interest rates has increased demand for perceived high-quality companies. Anecdotally, traditional fixed income investors have been increasing equity allocations while attempting to minimise additional risk. Likewise, the premium for companies growing at above average rates have benefitted from lowering of discount rates.

The lower interest rates go, the more sensitive valuations become to further reductions (or increases) in discount rates as opposed to changes in underlying cash  flows.

We can observe this by examining the relationship between long-term government bonds and the valuation premium (Figure 6).
Picture
​We struggle to believe that real interest rates will remain negative indefinitely. Reversion of real interest rates upwards towards long term averages highlight the significant downside risk to these lofty valuation premiums for quality.
Investing in quality less compelling over the long term
​

Ultimately, when we look at the long term evidence of whether certain definitions of “quality” warrant merit as a factor reflecting systemic bias in market pricing, the results are somewhat mixed. Over a full market cycle, the performance of both “high growth/return” and “low volatility” stocks have been mixed.

The average low growth/return stock has vastly outperformed the average high growth/return over a 15 year period (Figure 7). This is consistent with Merlon’s prior research (Value vs Glamour) which highlights the market’s bias in overpaying for high growth “glamour” stocks whilst avoiding low or declining growth companies that are behaviourally uncomfortable to own or justify to  clients.
Picture
​While the average “low volatility” stock outperformed over both the long run (2002- 2019) and post the GFC, this performance is largely matched by the “high volatility” stocks. Therefore, there is limited effectiveness in the volatility factor due its mixed performance.
Picture
Conclusion

“Even the world’s greatest business is not a good  investment,  if  the  price is  too  high.”  - Lou Simpson

The market often has a short memory. It is easy to look back at the ten-year bull market and conclude that owning “high quality” companies is an easy route to investment outperformance. Yet there is little evidence that this strategy, in isolation, works over  the long-term and through the fluctuations of the market  cycle.

Additionally, as the market crowds into these stocks, their premium to market’s multiple has risen to historically high levels. At the current point in the “quality premium” cycle, we are inclined to believe that these premiums should revert downwards to long-term averages over time.

The chart below highlights the large premium enjoyed by most “high growth/return” and “low volatility” stocks even on a forward-looking normalised free cash flow basis. We do own a handful of “quality” companies defined this way, but only because they offer valuation upside and we have conviction that market concerns are overly discounted into the current share prices (Figure 9).
Picture
​Considering the premium paid for “quality” attributes at present is well above historic norms, buying into “quality” runs a real risk of paying for good businesses but ultimately, making poor investments.

* As measured by FY1 EBITDA Margin, ROE over FY0 & FY3, Sales & EPS Growth; 3yr Historical + Forward

** As measured by Historical beta, FY1 consensus EPS dispersion , 2-month share price volatility, Market cap
0 Comments

Your comment will be posted after it is approved.


Leave a Reply.

    Markets & Commentary

    At TAMIM we are committed to educating investors on how best to manage their retirement futures.

    Sign up to receive our weekly newsletter:

    * indicates required

    TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.

    Archives

    June 2022
    May 2022
    April 2022
    March 2022
    February 2022
    December 2021
    November 2021
    October 2021
    September 2021
    August 2021
    July 2021
    June 2021
    May 2021
    April 2021
    March 2021
    February 2021
    January 2021
    December 2020
    November 2020
    October 2020
    August 2020
    July 2020
    June 2020
    May 2020
    April 2020
    March 2020
    February 2020
    January 2020
    December 2019
    November 2019
    October 2019
    September 2019
    August 2019
    July 2019
    June 2019
    May 2019
    April 2019
    March 2019
    February 2019
    January 2019
    December 2018
    November 2018
    October 2018
    September 2018
    August 2018
    July 2018
    June 2018
    May 2018
    April 2018
    March 2018
    February 2018
    January 2018
    December 2017
    November 2017
    October 2017
    September 2017
    August 2017
    July 2017
    June 2017
    May 2017
    April 2017
    March 2017
    February 2017
    January 2017
    July 2016
    June 2016
    March 2016
    February 2016
    January 2016
    December 2015

    Categories

    All
    Accounting
    AGM
    Amazon
    APRA
    Asia Small Cap
    Asset Allocation
    Aus Equity All Cap Value Portfolio
    Aus Equity Income Portfolio
    Aus Equity Small Cap Portfolio
    Australian Banks
    Australian Market Commentary
    Banking Royal Commission
    Big 4 Banks
    BNPL
    Brexit
    Budget
    China
    Corporate Governance
    Correlation
    Cryptocurrency
    Currency
    Darren Katz
    Dividend Yields
    Election
    Emerging Markets
    Energy
    GDP
    Global Equity High Conviction Portfolio
    Global Mobility
    Gold
    Guy-carson
    Housing
    Income Investing
    Inflation
    Infrastructure
    Insurance
    Interest Rates
    International Commentary
    Investment Thematics
    Investor Psychology
    Israel
    Japan
    Katz's Corner
    Kevin Smith
    Market Outlook
    Mergers-aquisitions
    Mobility
    Oil
    Passive-vs-active
    Peer-to-peer-lending
    Peertopeer-lending
    Portfolio Management
    Portfolio-management
    Private Debt
    Property
    Rando's Reflections
    RBA
    Recession
    REITs
    Reporting Season
    Retail
    Risk Management
    Robert Swift
    Ron Shamgar
    Small Cap Income Portfolio
    Small Caps
    Succesion Planning
    Telecoms
    The Pain Report
    Trade War
    Trump
    Value Investing
    Video
    ZIRP

    RSS Feed

TAMIM | Equities | Property | Credit
​

TAMIM Fund
Australia All Cap
Australia Small Cap Income
Global Mobility
Global High Conviction
Credit

Listed Property
TAMIM Property
Company
About
Contact
Insights
Invest Online
Login
Other
Privacy Policy
Terms & 
Conditions
​Disclaimer
Contact
Level 4, 55 Grafton Street
Bondi Junction, Sydney NSW, 2022

1300 750 007

ima@tamim.com.au

DISCLAIMER

​The information provided on this website should not be considered financial or investment advice and is general information intended only for wholesale clients ( as defined in the Corporations Act). If you are not a wholesale client, you should exit the website. The content has been prepared without taking into account your personal objectives, financial situations or needs. You should seek personal financial advice before making any financial or investment decisions. Where the website refers to a particular financial product, you should obtain a copy of the relevant product services guide or offer document for wholesale investors before making any decision in relation to the product. Investment returns are not guaranteed as all investments carry some risk. The value of an investment may rise or fall with the changes in the market. Past performance is no guarantee of future performance. This statement relates to any claims made regarding past performance of any Tamim (or associated companies) products. Tamim does not guarantee the accuracy of any information in this website, including information provided by third parties. Information can change without notice and Tamim will endeavour to update this website as soon as practicable after changes. Tamim Funds Management Pty Limited and CTSP Funds Management Pty Ltd trading as Tamim Asset Management and its related entities do not accept responsibility for any inaccuracy or any actions taken in reliance upon this advice. All information provided on this website is correct at the time of writing and is subject to change due to changes in legislation. Please contact Tamim if you wish to confirm the currency of any information on the website.  

magellen, kosec, clime, wilson, wam, montgomery, platinum, commsec, caledonia, pengana, tamim

  • HOME
  • INVESTMENTS
    • Equities >
      • Australia All Cap
      • Australia Small Cap Income
      • Global Mobility
      • Global High Conviction
    • Property >
      • Listed Property
      • TAMIM Property
    • Income >
      • Credit
  • INSIGHTS
    • Insights
    • Weekly Reading Lists
  • ABOUT
  • CONTACT