Relative to the other investment factors, quality occupies an interesting place of being overlooked yet highly debated.
It's one of the most durable investment styles, but fluidity in definition often acts as a barrier to quality adoption. That shouldn't be the case because this style is efficacious in boosting long-term client outcomes and easy to implement within portfolios. Advisors simply need to know what building blocks to start with.
“The oft-cited profitability metric is return on equity (ROE), while the debt part is sometimes found by checking how the company stacks up in the context of return on assets (ROA),” says WisdomTree Head of Equity Strategy Jeff Weniger. “If ROA is low and ROE is high, we know how the firm achieves it: management gooses the balance sheet with debt.”
Fortunately, quality is highly accessible in fund form, though advisors should remember the aforementioned point about fluidity in defining quality because that fluidity is apparent among fund issuers and index providers.
While WisdomTree focuses on ROA, ROE and leverage, other quality offerings emphasize traits such as earnings quality, profitability, efficiency and accruals ratio, among others.
Better Quality Mousetrap
Noting that quality is multi-definition concept that can be applied in varying forms and fashions, advisors are right to ponder what the superior applications are. Fortunately, there's available insight into the matter.
“The intellectual framework for ROE is intuitive. Look for three things: business strength, stability and operational efficiency. Each is in the DuPont equation, which shows how quality—or ROE—is simply the interaction between profit margins, business efficiency and balance sheet risk,” adds Weniger.
Translation: An efficient avenue for ramping up quality within portfolios is too focus on high ROE names with manageable or no debt burdens.
Indeed, that's a compelling mix and one that's likely to serve patient clients well, but it's also important to convey to clients that quality isn't a holy grail, meaning there are times when it trails the broader market.
“Quality has been lagging in this 15+ month market moon shoot. Sure, you could have bigger problems in life than watching the S&P 500 Quality index go up 'only' 95.6% since March 23, 2020. Nevertheless, that is 4 percentage points short of the 99.7% run in the S&P 500 off the COVID-19 lows,” according to WisdomTree's Weniger.
Don't Worry, There's Good News
In an effort to keep cool heads regarding quality's recent laggard status, it's worth noting that quality stocks are now inexpensive – in some case sporting valuations below those of value stocks.
Second, while factor timing is certainly tricky, now could be a good time for advisors to discuss quality allocations with clients because the evolving economic cycle confirms quality could be ready for more time in the limelight.
“Though low quality has been running higher as the COVID-19-inspired economic depression transitioned to early recovery, one of these days we will enter the middle of the economic cycle—if that stage is not already here,” concludes Weniger. “The impulse to buy anything and everything, with little regard for operational efficiency, should seemingly fade as the clock ticks. That environment would enable quality concepts to claw out of this tunnel of frustration.”
No, there's never a bad time to embrace the concepts of high ROA and ROE and low leverage, but that appears to be a particularly strong idea today.
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