Over the past few weeks, we have seen a widening market rout which has seen the share prices of many growth stocks fall over the year so far. The selloff was particularly brutal among tech companies, with the ASX All Tech Index falling 24% in early March. It’s down another 20% since then, some of the notable fallers including buy now pay later ZIPCo (ASX: Z1P) and lifestyle app company Life360 (ASX: 360)which are down about 90% and 70% since the beginning of the year.
Value stocks join growth downtrend
But as the chart above shows, the sell-off also hit value stocks early in the month, due to deteriorating US inflation numbers. Within the resources and materials sectors, the stock prices of the following companies fell between 8% and 16% between June 9 and June 15:
- oil and gas company Woodside Energy Group (ASX:WSD)
- energy service company Worley (ASX:WOR), and
- Mining and metallurgical company South32 (ASX: S32).
Beyond the values of value and growth, that leaves quality. Rather than relatively low stock prices or good prospects for continued growth, these companies are distinguished by strong balance sheets, high return on equity and good cash flow.
In the first of this two-part series, I ask the following three fund managers about their views on the quality cohort and how they find ASX-listed companies that meet their definition.
They each explain how they define quality as an investment style and how they find stocks that meet these criteria. They also report a few red flags that they are watching.
Avoiding value traps is key
Michael O’Neill, Investors Mutual
Simply put, a quality investor sees companies with sustainable competitive advantages. I don’t think anyone wants low quality, but if you take a narrow perspective on it or start using rules of thumb like return on equity, you might find yourself going to companies that earn too much , especially in the current market environment. . You might also end up buying high-risk cyclical companies or those with too much debt. We must therefore be much more complete.
Quality floats as rates rise
When fares are low, it’s a rising tide that lifts all the boats, but you differentiate quality much more when fares are up. Some red flags might include an inability to pass on the costs of doing business; or a business may have cyclically high returns – such as discretionary retailers. And in some extreme cases, you might have companies that cannot invest for quality reasons. For example, they may be over-leveraged, have short-term refinancing obligations pending, or have significant governance risks.
To me, it makes a lot of sense to think about quality independently of valuation, in order to avoid getting stuck in this nuanced debate around growth and value. It gives you two sets of opportunities
- Mid-quality companies available at deeply discounted prices, which are unloved and which are candidates for a revaluation of the share price. For example, they might have the potential to restructure a division to reduce costs.
- Top quality companies that you might want to buy at a fair price – these are the companies that generate very good profits and can reinvest.
We target both – it’s just as much about avoiding value traps – seemingly cheap businesses with unsustainable cash flow. I don’t think “cheap” is a case of investment per se.
How do we find quality?
We break them down into franchise, management and financial strength. And there is a fourth – the sustainability of operations, particularly with regard to the environment, social and governance (ESG).
It is tricky and can be both qualitative and quantitative. But we rate companies on all of those counts, and once we have that, it gives us confidence in our willingness to pay more because we can gauge their future cash flows with more certainty.
When you remove low-quality potential value traps, you potentially carve out a quarter of your investment universe, removing many cyclical stocks, such as those with “one mine, one commodity”, as well as some of the most speculative growth whose price is valued. on revenue rather than earnings growth multiples
“The investment coin has three sides”
Jason Teh, Vertium Asset Management
In the academic literature, high quality companies are those that offer high returns on equity. To some extent, this is true because high ROE companies have more opportunities to sustainably produce more profit compared to a low ROE company. For us, quality is more about the sustainability of profits than the narrow definition of using ROE.
When thinking about earnings sustainability, there are two very big red flags to keep in mind:
- sales volatility and
- the strength of a competitive advantage, where competition can quickly impact profits.
It is often said that value and growth are two sides of the same coin. High growth companies should be better valued and vice versa. But what is not well understood is that the investment coin has three sides. Quality is the other dimension of the value equation. The more sustainable the stream of benefits, the more investors should value it based on a lower discount rate. Thus, high quality companies should also be better valued and vice versa.
Typically, high growth companies are high quality companies with high ROE. This is because sustaining earnings growth over a long period of time requires high-quality earnings. But not all high growth companies are high quality. For instance, Transurban (ASX: TCL) is a capital-intensive business that does not have a high ROE. It is not considered a high growth company, but the sustainability of its earnings is extremely high given that no one else can build a competitive road network next to its assets.
7 Pillars of Quality Businesses
Jason Woerner, Elston Asset Management
We think of quality in terms of companies’ ability to weather any storm. All businesses face a range of potential risks, such as:
- changing consumer preferences,
- new competitors entering the industry,
- technological developments, or
- regulatory developments.
We consider seven pillars of quality:
1. Favorable industry structure: we favor natural growth industries, which offer companies a favorable structural wind for revenue growth. We avoid today’s buggy whip industries.
2. Wide moat: companies with strong and sustainable competitive advantages, strong customer propositions and high barriers to entry that make it extremely difficult for competitors to take market share.
3. Financial strength: a key lesson from GFC and particularly relevant in an environment of rising interest rates and tighter refinancing. We target companies with little or no debt and high gross margins.
4. Robust organic growth: Quality companies operating in large addressable markets where penetration is low can grow revenue organically, avoiding high-risk acquisitions.
5. Management: it is more a question of seniority than of quality. We prefer companies where the current management team is the one who was responsible for building the company and setting up the historical journeys.
6. Corporate culture: companies with strong cultures where all stakeholders are valued.
7. Low ESG risk: companies with a low level of ESG risk.
The red flags we look for involve unexpected changes in strategy, management team or finances. This may include major acquisitions or sweeping programs outside of the company’s core values, departures of the management team or the hiring of external executives, profit warnings, deteriorating margins or increased capital investments.
How do we find quality?
In our view, it is the qualitative aspects of our businesses that allow them to generate high growth rates. It is therefore quality that drives growth, but with a higher degree of predictability and longevity than growth itself.
We screen all listed companies outside of the ASX100 up to a market capitalization of $150 million, to identify attractive opportunities. We try to remove the influence of short-term cycles from our decision-making, whether value/growth, cyclical/non-cyclical or macro-related. We take the time to understand the fundamentals and implement a disciplined investment process, based on checklists and team engagement, to assess each company against our quality pillars.
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Be sure to “FOLLOW” my profile to be notified when the second and final part of this series is released. In part two, our contributors will each discuss one of their favorite quality stocks in the current market environment.