Quality & Patience

Quality & Patience

Today, asset owners have an unprecedented range of options of where to invest and an even greater number of well-argued reasons for why each of these will be the most attractive home for their capital. Aggressive, untested monetary policy has helped fuel years of above-average equity returns, encouraging many of those who run these strategies to predict handsome returns for investors.

Years of strong returns have also intensified the tolerance for risk. The substitution of capital loss with relative return, as a definition of downside, has become worryingly common, as has the fear of missing out on the attractive returns generated by popular names of the day. These behaviours distract from the importance of capital preservation for the long-term growth of capital. 

These distractions are present whether you believe that long-term protection and growth of capital is best served by an active manager, ‘Smart’ beta strategy or passive fund. 

Owning a passive fund heavily weighted to expensive, large and popular companies due to its relative cost or because the definition of risk has regressed from the protection of capital to volatility from a benchmark, means that capital preservation is no longer regarded as central.

Smart beta has become an increasingly popular option for asset owners. Proponents of these strategies argue it offers exposure to the best of both active and passive worlds – offering factors which have explained historic ‘excess’ returns at a cheaper fee than their active counterparts. Popular factors are typically size, value, momentum, quality and low volatility. 

We are quality investors, so we are naturally interested to understand what is in a Quality Index1. The definition of quality varies, depending on who is providing the index. The MSCI Asia ex Japan Quality Index, for example, defines Quality as a company with high returns on equity2, low levels of debt and low levels of earnings variability. 

We would argue this is not quality investing but rather ‘high return on equity, low debt and low earnings volatility’ investing. This is a mere subset of quality. Instead, we look for quality in terms of people, franchise, financials and sustainability. 

These quality factor portfolios are created looking in the rear view mirror and importantly lack any scepticism of the fundamentals. Consequently, there is a high chance they end up owning the quality companies of yesterday. They assume that historically attractive returns on assets will be translated into similar returns on future investments and, other than (historic) consistency of earnings growth, there is no insight similar to what we would look for in quality of earnings such as: are earnings being turned into cash or, even better, free cash flow? Are high returns the result of underinvestment in the business? Have they proven themselves resilient through times of stress? What are the trends driving growth and are they sustainable? 

We would not own a number of the largest companies in the MSCI Asia ex Japan Quality Index, either due to sustainability headwinds facing earnings (tobacco and fast food franchises) or the hit-driven nature of their businesses (online games). 

Any consideration of valuation is also absent. High quality businesses tend not to translate into high quality investments if valuations are unjustifiable - a situation very common today. An Indian consumer company with a market cap3 of USD45bn is the fifth largest in the MSCI Asia ex Japan Quality Index. Despite being run by high quality management and owning some of India’s strongest brands, we do not own it for clients due to its high valuations. 

Viewing quality through a purely quantitative lens will also miss those companies investing in long-term capabilities at the expense of short-term profitability. We have found such companies, when operated by competent management teams who are owners or at least think like owners, have been lucrative long-term holdings for clients. These management teams tend to be more interested in the long-term creation of wealth rather than satisfying value-destroying distractions like quarterly expectations or reducing the volatility of earnings. 

This ability to think and act like an owner is one factor that our qualitative philosophy emphasises. Gaining comfort in the stewardship and thought process of the allocator of a companies’ capital is very difficult to distil into an algorithm, as is collecting evidence that a company has cultivated a time horizon and culture capable of leveraging and preserving the strength of a franchise, a characteristic central to incorporating sustainability challenges into their thinking. One of our family-owned companies puts it like this: ‘we pay attention to not only the what we do, but the how we do it’. We have found these factors have a strong bearing on a company’s long-term success.

Although sounding simple, owning a company for the long-term is not easy. Constant news flow and short-term volatility in share prices conspire to pull on our many behavioural flaws. Persevering through these shorter term pressures requires values that a smart beta strategy cannot offer: patience, scepticism and trust. 

Within our investment philosophy, trust is a critical factor when investing clients’ capital. We must believe that the people at the company are suitably aligned with our time horizon, values and objectives - that they will not expropriate our clients’ capital, either through malicious behaviour or incompetent capital allocation. Studying and understanding the decisions and outcomes that have been made in the past, in the good times and more crucially the bad, increases our ability to trust in the decisions they will make in the future. 

Why is this important? The longer a company is held, the more important the quality of people becomes. Over short time periods, market noise dominates returns, while over longer periods, the resilience of the business, return on investment and earnings growth drive returns – outcomes of quality decision making. In contrast, we believe investing alongside poor quality people is the surest way to destroy capital permanently and we will sell our position if trust has been lost, even if the company is earning high returns on equity, has low levels of debt and high historic earnings growth. 

As patience is the capacity to delay reward, it requires that you believe there is something worth holding out for. For an investor, being able to stay invested through the tough as well as the good times, is key to the long-term compounding of capital4. A lack of patience also tends to lead to chasing ‘game-changing’ companies of the hour. Owning these companies provides the sense of security that comes with being part of a crowd, but results in paying valuations that reflect their popularity. Such behaviour conspires to destroy capital and obstruct the power of compounding. 

Discipline to stick with an idea or stay on the side-lines and buy at more attractive valuations sounds simple but is not easy. Factor portfolios are by their very nature impatient. They are constantly rebalanced to reflect the new quality companies of today which increases trading costs, reduces returns and again gets in the way of long-term compounding of returns.

We have found that the best quality management teams also tend to be the most patient. Often turning this skill into a competitive advantage, world class businesses are not built in a day and the best are constantly evolving. Again, trusting in a management team or a steward makes holding on far easier than if a portfolio is seen as a collection of a stock prices or Bloomberg tickers. 

When owning a quality factor-based portfolio, the asset owner is trusting that the index provider has distilled quality into a few, easily measurable metrics and, most importantly, that the future will resemble the past. This is an important consideration given it is unlikely the provider has their own capital invested alongside its clients, a consequence of the strategy’s creation having more to do with the profitability of the provider’s business than conviction in the ability to protect and grow capital. Lower fees tend to mean more assets. Historically this has proven destructive to client returns. 

If performance of the index runs into trouble as most strategies do at some point, what is to stop the investor questioning its legitimacy, running out of patience and moving onto the next ‘winning’ factor? We believe there is very little. It is a strategy which makes the preservation of capital even harder than it already is. 

Our long-term philosophy requires clients to trust us not to deviate from identifying and owning high quality businesses run and owned by high quality people. It also requires that they trust us to act as if their money was our own. 

The reciprocation of trust and patience between clients, investment team and companies held on behalf of clients, should allow us all to stay focused on what is important - the long-term preservation and growth of capital. 

It is a simple notion but one that is increasingly rare today.

Footnotes

  1. An index made up of companies that are regarded as ‘quality’ ones.

  2. Return on equity is a measure of the profitability of a company.

  3. Market cap is the value of a company on the stock market.

  4. Compounding refers to the increasing value due to interest earned on both principal and accumulated interest.

Investment terms

View our list of investment terms to help you understand the terminology within this website.

Subscribe to our updates

To get regular updates and content from Stewart Investors, please register here.

Important Information

This material is for general information purposes only. It does not constitute investment or financial advice and does not take into account any specific investment objectives, financial situation or needs. This is not an offer to provide asset management services, is not a recommendation or an offer or solicitation to buy, hold or sell any security or to execute any agreement for portfolio management or investment advisory services and this material has not been prepared in connection with any such offer. Before making any investment decision you should consider, with the assistance of a financial advisor, your individual investment needs, objectives and financial situation.

We have taken reasonable care to ensure that this material is accurate, current, and complete and fit for its intended purpose and audience as at the date of publication. To the extent this material contains any measurements or data related to environmental, social and governance (ESG) factors, these measurements or data are estimates based on information sourced by the relevant investment team from third parties including portfolio companies and such information may ultimately prove to be inaccurate. No assurance is given or liability accepted regarding the accuracy, validity or completeness of this material and we do not undertake to update it in future if circumstances change.

To the extent this material contains any expression of opinion or forward-looking statements, such opinions and statements are based on assumptions, matters and sources believed to be true and reliable at the time of publication only. This material reflects the views of the individual writers only. Those views may change, may not prove to be valid and may not reflect the views of everyone at First Sentier Investors.

To the extent this material contains any ESG related commitments or targets, such commitments or targets are current as at the date of publication and have been formulated by the relevant investment team in accordance with either internally developed proprietary frameworks or are otherwise based on the Institutional Investors Group on Climate Change (IIGCC) Paris Aligned Investment Initiative framework. The commitments and targets are based on information and representations made to the relevant investment teams by portfolio companies (which may ultimately prove not be accurate), together with assumptions made by the relevant investment team in relation to future matters such as government policy implementation in ESG and other climate-related areas, enhanced future technology and the actions of portfolio companies (all of which are subject to change over time). As such, achievement of these commitments and targets depend on the ongoing accuracy of such information and representations as well as the realisation of such future matters. Any commitments and targets set out in this material are continuously reviewed by the relevant investment teams and subject to change without notice.

About First Sentier Investors

References to ‘we’, ‘us’ or ‘our’ are references to First Sentier Investors, a global asset management business which is ultimately owned by Mitsubishi UFJ Financial Group. Certain of our investment teams operate under the trading names FSSA Investment Managers, Stewart Investors, RQI Investors and Igneo Infrastructure Partners, all of which are part of the First Sentier Investors group.

We communicate and conduct business through different legal entities in different locations. This material is communicated in:

  • Australia and New Zealand by First Sentier Investors (Australia) IM Ltd, authorised and regulated in Australia by the Australian Securities and Investments Commission (AFSL 289017; ABN 89 114 194311)
  • European Economic Area by First Sentier Investors (Ireland) Limited, authorised and regulated in Ireland by the Central Bank of Ireland (CBI reg no. C182306; reg office 70 Sir John Rogerson’s Quay, Dublin 2, Ireland; reg company no. 629188)
  • Hong Kong by First Sentier Investors (Hong Kong) Limited and has not been reviewed by the Securities & Futures Commission in Hong Kong. First Sentier Investors, FSSA Investment Managers, Stewart Investors, RQI Investors and Igneo Infrastructure Partners are the business names of First Sentier Investors (Hong Kong) Limited.
  • Singapore by First Sentier Investors (Singapore) (reg company no. 196900420D) and this advertisement or material has not been reviewed by the Monetary Authority of Singapore. First Sentier Investors (registration number 53236800B), FSSA Investment Managers (registration number 53314080C), Stewart Investors (registration number 53310114W), RQI Investors (registration number 53472532E) and Igneo Infrastructure Partners (registration number 53447928J) are the business divisions of First Sentier Investors (Singapore).
  • Japan by First Sentier Investors (Japan) Limited, authorised and regulated by the Financial Service Agency (Director of Kanto Local Finance Bureau (Registered Financial Institutions) No.2611)
  • United Kingdom by First Sentier Investors (UK) Funds Limited, authorised and regulated by the Financial Conduct Authority (reg. no. 2294743; reg office Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB)
  • United States by First Sentier Investors (US) LLC, authorised and regulated by the Securities Exchange Commission (RIA 801-93167)
  • other jurisdictions, where this document may lawfully be issued, by First Sentier Investors International IM Limited, authorised and regulated in the UK by the Financial Conduct Authority (FCA ref no. 122512; Registered office: 23 St. Andrew Square, Edinburgh, EH2 1BB; Company no. SC079063).

To the extent permitted by law, MUFG and its subsidiaries are not liable for any loss or damage as a result of reliance on any statement or information contained in this document. Neither MUFG nor any of its subsidiaries guarantee the performance of any investment products referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of MUFG or its subsidiaries, and are subject to investment risk, including loss of income and capital invested.

© First Sentier Investors Group