Why Value Investors Need to Be Quality Investors, Too

Value investing has been overshadowed by growth stocks in the recent past, but that doesn’t mean the strategy is gone for good. On the contrary, experts say the markets may be poised to bring value back into favor.

Growth and value mirror each other, says Ted Snow, founding principal at Snow Financial Group. “Right now, the metrics measuring the difference between growth- and value-oriented companies are at a historic dichotomous high,” with growth high and value low.

“When we see things at these kinds of extremes, my experience has been to take heed of the sign and act accordingly,” Snow says. “As long as value has lagged, there will be a time when it leads and maybe for a long stretch of time.”

That time may be nigh. “We may reasonably assume that we may be near a pendulum swing back in favor of value-oriented companies,” Snow says.

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Value Investing Needs a Quality Component

Just going after value isn’t enough. Deeply undervalued companies can be highly risky. Investors could easily end up in value traps, wherein they buy a company that is significantly undervalued thinking it will produce above-average returns going forward, only to find the reverse happening. This can happen for several reasons, from deteriorating fundamentals to a change in the market or competitive landscape.

To avoid winding up in a volatile and risky value trap, Tony Cousins, CEO and chief investment officer at Pyrford International, a division of BMO Global Asset Management, adds a quality metric to his value approach, implementing a style sometimes referred to as quality income investing.

Unlike pure value investing, quality income investing captures less of the downside during bad markets, enabling investors to preserve more capital in such times, Cousins explained recently at the Schwab IMPACT 2020 conference.

Cousins showed a comparison with the Pyrford International Ltd Equity Composite, which takes a quality and value approach, to the MSCI EAFE Index, which tracks large and mid-cap securities from 21 developed foreign markets, from March 31, 2000 through June 30, 2020. During that period, Pyrford’s quality income approach experienced only about two-thirds of the downside of the index.

[Read: Schwab Independent Advisor Outlook Study: The Future of the RIA Industry.]

The flip side of this is that quality income also catches only a portion of the upside over the last 20 years, which was about 87%. This combination of lower downside and upside capture results in a smoother ride for investors and what some call the volatility anomaly.

“Volatility is associated with risk, so lower volatility should mean lower risk which should mean lower rewards, but that isn’t what comes out of (quality income investing),” Cousins says. “What you get is lower volatility plus higher long-term returns thanks to the reduced downside capture.”

How to Find Quality Value Companies

To implement a quality and value approach, Cousins looks for higher than market dividend yield, lower than market financial leverage and above-market return on equity.

Buying high dividend-yielding stocks “does generate superior performance in the long term, so that’s what we look for in aggregate for our portfolio,” he says.

Not every stock has to have an above-market dividend yield, but the overall portfolio should.

He also looks for high ROE, but the ROE cannot be driven by financial leverage. The easy way for companies to increase ROE is by putting a lot of cheap debt on the balance sheet, he says, but this is not sustainable.

Lower than market leverage is what leads to the low downside capture that is vital to the quality income approach, he says.

[Read: Liz Ann Sonders — Stock Market Outlook for Q4 and 2021.]

“The mark of a good business model is one that drives its ROE through asset turnover and/or margin,” Cousins says. “It’s making something, whether a product or service, that people want to buy more of and that comes through in asset turnover.” Since most businesses have some element of economies of scale, this will also translate into expanding margins.

The question then becomes: Is this ROE sustainable? To answer this, Cousins likes a framework developed by Michael Porter, a Harvard University professor of microeconomics, which looks at the following forces to determine a company’s competitive landscape and long-term profitability:

1. Look at the barriers to entry.

“Barriers to entry, what (Warren) Buffett calls the mote, is very, very important,” Cousins says. These can take many forms from a technological advantage to brand distinction or copyright or patent.

2. Look for threats of substitution.

Is there the potential for new products and services to come along and steal a business’s advantage? “A great disrupter is Amazon (ticker: AMZN),” Cousins says. “You don’t want a company that is standing in front of the Amazon steamroller because they will get flattened.”

3. Another force is Porter’s framework is pricing discipline.

“Nothing will kill profitability quite like a price war, even for the strongest player,” Cousins says. “So avoid industries which are highly fragmented and have a history of disruptive price players.”

4. The pricing power of a company relative to its customers and suppliers.

Is the company David fighting Goliath? Cousins asks. “If you’re selling stuff to General Motors ( GM), they’re not going to let you have a high ROE because they’re a 600-pound gorilla who can price you down and take your margin and therefore your profitability away.”

If you find a company that can stand up to this level of fundamental analysis, you should have a long-term winner in your portfolio. And if you can build a portfolio of high-quality value companies, you should have a cushion against market downturns.

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Why Value Investors Need to Be Quality Investors, Too originally appeared on usnews.com

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