Equity styles: Quality is in the eye of the beholder

Ronak Patel - Redington

Ronak Patel

Analyst, Manager Research
(Wednesday, May, 25, 2022)
|   3 mins

We like to think about equity investing through a style lens. After all, styles can often explain the out and under-performance of fund managers versus their respective benchmarks over both the short and long term.

There are many styles out there, such as ‘growth’, ‘value’ and even variations like ‘GARP’ (Growth at a Reasonable Price). Defining these can sometimes be nuanced. In our team, we like to split the universe into three dominant investing styles: Value, Quality and Momentum.

The world would be a simple place if every equity manager sat neatly in one of these boxes. Unfortunately, the reality is far different. For the purpose of this blog, we’ll dig into the definition of Quality as it arguably has the most variation within it.

The Quality spectrum

On one end of the spectrum is ‘quality-value’ – that is, Quality managers who are valuation disciplined and spend a lot of time ensuring they don’t overpay for a high-quality company. These managers tend to be more absolute return-oriented and are often more cautious, devoting significant resources to formulating a view on the valuation of companies. At this end of the scale the line between Value and Quality can become blurred, as Value managers themselves will spend a lot of their time assessing company quality to avoid value-traps.

On the other end you’ll find ‘quality-growth’ managers. These managers may be less interested in company valuations and more focused on forward-looking quality – that is, companies that can become future leaders or further solidify their existing strong market positions. These companies might be reinvesting heavily for their growth, which will depress common profitability measures like return on equity (ROE).

The following chart shows some of this dispersion through headline performance. In general, growthier Quality funds have experienced more extreme drawdowns in the recent market rotation, whilst valuation-aware strategies have outperformed.

Source: eVestment, Redington. Data as at 31 March 2022. The universe is all active, global ‘quality’ strategies as defined by eVestment with some additional adjustments. Past performance is not a reliable indicator of the future results or performance of any investment.

Other nuances

Some managers may simply define Quality differently. For example, having a preference for stable returns over high returns, as the predictability of earnings may outweigh the level of earnings in terms of importance. The Utilities sector reflects this the most – companies here often have limited upside potential due to regulations surrounding their profits, however, they might operate in a natural monopoly with almost guaranteed revenue streams. Other managers avoid these names due to their capital intensity, preferring capital-light business models seen in other sectors like Technology.

These managers can have very different portfolios and performance profiles despite technically being ‘Quality’ investors as well.

So, are styles useful?

Although in practice there’s a lot of variability between managers (and some managers fall between styles), style buckets provide a simplified way to think about the thousands of strategies available in equity investing.

Despite the nuances, we believe understanding styles is essential. To start with, we want managers to understand what market inefficiency they are exploiting and therefore why their approach to investing should be rewarded. It is impossible to have a clear investment philosophy without a clear investment style.

Appreciating styles also helps us better understand performance and attribution. Our role as manager researchers is to distinguish between luck and skill – so being able to identify style headwinds and tailwinds puts performance into perspective, and improves our manager appraisal process.

Styles are a useful tool when making portfolio construction decisions too. We aim to build well-diversified equity portfolios for our clients – to ignore style exposures when doing so would be amiss.

Overall, we believe this way of thinking strengthens our evaluation of equity managers and ultimately improves the quality of our recommendations. For help identifying best-in-class equity managers, please get in touch: ronak.patel@redington.co.uk.

 

Unless indicated, these are the views of the author and may differ from those of the firm.

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