Quality: Outperformance Without the Risk?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Do quality stocks outperform, and if so, how should investors incorporate them into their portfolios? Joining me to discuss that topic is Ben Johnson. He is director of global exchange-traded fund research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, in your latest issue of [the] ETFInvestor [newsletter], you have a piece about high-quality companies and some of the ETFs that have sprung up to capitalize on the quality factor. Before we get into that, can we talk about the factors, the specific attributes that tend to underpin a quality strategy?

Johnson: So quality is one of many factors that exist out there, these components of investment returns. So, it's there with things like value and momentum, size, and now quality. There is some debate as to whether or not quality is a true factor, but many are certainly believing it, and certainly there more and more funds and exchange-traded products out there that look to harness this quality factor. The trouble with quality in part is defining it, because there are so many different definitions of it, no two are alike. So, some of the common threads amongst varying parties' definitions of quality are really profitability, and consistent profitability.

Benz: So looking at steady ROE, other factors like that?

Johnson: Steady ROE, steady returns on capital, ideally a limited degree of earnings variability, so that earnings stream that any given stock is producing is not going to zig and zag very violently, it's going to be fairly steady across a full economic or market cycle. The other common thread is, as it pertains to financial health. So, generally quality firms tend to have squeaky-clean balance sheets.

The last element really pertains to sort of management efficiency, which is in many ways kind of a hybrid of profitability and financial health, are the managers of a given firm taking sales dollars and converting them very consistently, very readily into profits that they then deliver to shareholders? So those three sort of core criteria are vaguely similar across all of these very seemingly diverse definitions of quality.

Benz: So some of the unifying themes. So let's talk about performance of this basket of quality companies you cited in your ETFInvestor story, some AQR research, some research from Cliff Asness and his team, pointing to high-quality companies as having outperformed without necessarily any extra risk.

Johnson: And that presents a real sort of conundrum. It's a head-scratcher for many academics, because that risk story is absent. So, the value premium can be explained to a certain extent by the amount of risk that investors are taking by investing in beaten-down value stocks whose fundamentals look poor. There has to be a degree of compensation from the point of view of a rational investor to assume that risk.

Now, looking at a high-quality company, looking at, say, Coca-Cola for example, one might wonder, what's the risk story associated with quality. It's not apparent, and frankly it probably doesn't really exist. So, how do we explain quality then? There are a number of different, I think, attempts that have been made to do that.

One of them reflects somewhat on a behavioral explanation, so people fail to appreciate just how consistently profitable high-quality companies will be, and as such they don't pay enough for them. And they consistently underpay for quality companies, which continue to grow their intrinsic worth over time at a rate faster than we had expected--maybe, maybe not.

The other explanation is somewhat more institutional in nature. So mutual funds, for example, need to sort of hit certain bogeys. They need to deliver for their end investors. They only have so many ways in which they can do so, and generally speaking they cannot employ leverage. What they can do is try to sort of create "leverage" by investing in more volatile, higher-beta stocks, so basically buying lottery tickets.

So there's this "lottery ticket" explanation whereby investors, particularly professional investors who were trying to beat their benchmark, might buy a fistful of lottery tickets in hopes of getting up and above that benchmark, delivering for their shareholders. And while they're buying these lottery tickets, they are ignoring quality firms.

Benz: High-quality piece, I see.

Johnson: Leaving them alone, not bidding their prices up. So that's another explanation. Another one that I don't know if it necessarily gets us all of the way there, but has been used to explain why quality stocks, without the risk story there, would produce excess returns over a long period of time.

Benz: Okay. So, let's talk about the timing, because high-quality stocks even though there may be some data to support that they are attractive investments, they won't always been attractive. There will be better times to own them or perhaps overweight them and times where you'd perhaps want to pull back on them, because they look expensive. Let's discuss that piece of it.

Johnson: Right. So, to channel Warren Buffett, good companies at fair prices. Buffett was never quoted as saying, good companies at obscene prices; so price matters. It matters when you're looking at quality companies. It matters when you're looking at the value factor, the size factor, the low-volatility factor. The fundamental sort of recipe for success in investing, as glib as it might sound, is to buy low and sell high, and not the reverse. So, quality right now tends to look fairly priced if not somewhat richly valued, and part of that can be explained by the fact that we're beginning to see inklings of a flight to relative safety.

We're seeing more and more investors move their assets into higher-quality firms, because historically they have tended to hold up quite well in the later stages of the bull market and certainly, during sort of a correction or bear market as well. These are lower-beta stocks, the underlying franchises again tend to be consistently profitable throughout a market cycle. So, they tend to be a preferred destination of many investors who are looking to seek shelter in stormy market conditions.

Benz: There have been other times though in market history where high-quality companies have gotten notably cheap. Can you talk about one or two of those?

Johnson: Sure. So, if you look at the runup to the dot-com bubble, I think that's a perfect example where you saw some of that exact behavior I described earlier, where investors were not buying just one fistful of lottery tickets, maybe they were buying two fistfuls of lottery tickets or maybe they just had two fistfuls of shares in Pets.com. So, quality was being ignored, and ignored in a big way, and got really quite cheap relative to the market at large as the multiple on the S&P 500 expanded as sort of this whole concept of the new economy sort of captured the collective imagination of investors and bid share prices up to astronomical levels.

Benz: And listening to you talk about high-quality companies, I have a feeling if investors have built well-diversified portfolios and maybe focused on some of the criteria that you've talked about, they probably don't need a fund [or] ETF that is specifically set up to deliver quality; it may already be in their portfolios. Is that right?

Johnson: You probably already own a portfolio of high-quality companies, if you've done exactly that. So, while there are ETFs out there that specifically look to either harness quality in isolation. So, a perfect example there would be the iShares MSCI USA Quality Factor ETF--the ticker for that is QUAL--that looks to really focus in on quality companies, harness that quality premium. Now it does so by a very deliberate process and when I say "process" here, I mean process as defined by the construction of that fund's index. Now, different processes can yield a similar end product.

So, perfect case in point would be the Vanguard Dividend Appreciation ETF, VIG, or the Schwab US Equity Dividend ETF, SCHD. Now, neither of those funds has the word "quality" in their name nor in the name of their benchmark, but what they do is they build a portfolio of dividend-paying equities, those that ideally have paid consistent dividends and have grown their dividends with time. And what we see, to little surprise, is that those funds have a very high degree of exposure to that very same quality factor. So, odds are if you have a well-diversified portfolio, you already have a huge segment of your portfolio invested in all of these high-quality companies that we've already described, regardless of the fact of whether or not the funds you invest in specifically set out to isolate quality, the factor.

Benz: Last question for you, Ben. When you look at this basket of high-quality companies do they tend to be large companies or are there small and midsize quality companies as well?

Johnson: So, quality companies exist from top to bottom as you move down the market-capitalization ladder. They tend to be more common at the top, in large and mega-cap firms--the Coca-Colas of the world. These businesses are just inherently bigger, they've got bigger balance sheets, they've got bigger sales bases, they've got product lineups and franchises that are just inherently less volatile and more mature. They are not having to regularly reinvest to continue to grow their business. Now, you move further down the spectrum into small-capitalization names and quality firms are still there, they are just somewhat rarer.

Benz: OK, interesting topic, Ben. Thank you so much for being here to discuss it.

Johnson: Glad to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.