Ignore the hype and focus on quality

Investors have seen stellar returns in recent years by many growth managers, with strong performances by software, e-commerce, and biotech names pushing indexes to new heights. The allure of chasing hyped up growth and unproven business models can be strong in a market like this, but Tom Hancock from GMO instead suggests a ‘slow and steady’ approach.

“Many people talk of Quality-Growth as if it were a single style…. But Quality investing is about investing in proven companies and business models, and so tends to avoid the most hyped up and unproven business models.”

In this Q&A, Tom explains how Quality differs from Value and Growth styles, the impact of Quality-focused ETFs on their opportunity set, and he shares a couple of high-quality companies he’s interested in today.

What is Quality investing, and how does it differ from Value and Growth styles of investing?

When we think about what quality means to us, we look for three attributes in the companies we invest in:

1. Relevance: Companies that do something important now and for a long time to come.
2. Strong competitive positions: Companies where a rival cannot come in and take away what they do or diminish its profitability.
3. Great management teams: Companies with management teams that invest with a long horizon and deploy capital responsibly in a prudent way.

A portfolio comprised of these types of companies should be one that you can hold through thick and thin without having to worry about the events of the moment. It should protect from paying too much for growth that never materializes or falling into value traps.

We think of Quality as a third way. Many people talk of Quality-Growth as if it were a single style. And certainly, an emphasis on relevance and strong competitive positions is aligned with a growth tilt. We are allergic to businesses in secular decline that tend to infest value portfolios. But Quality investing is about investing in proven companies and business models, and so tends to avoid the most hyped up and unproven business models. We practice Quality investing with a valuation discipline, and so our portfolio tends toward neutrality on value vs growth.

What initially attracted you to this style of investing?

The myth of Icarus has a powerful hold on me. I think many investors are too ambitious and fly too close to the sun. That can be true for aggressive growth projections as well as the greed of value managers trying to get fantastic returns if only some failed business can rebound to former glory. Quality investing is about “slow and steady wins the race”. If you don’t focus on hype and fashion you can win in the long run, and that appeals to me.

Has the increased popularity of Quality ETFs affected the number of opportunities available to you as an active manager?

Quality ETF’s are flawed as they are only backward looking and so miss deterioration of a business or the emergence of new business models. They are also blind to valuation in many cases, and some are even sector neutral, which is absurd given that Quality is disproportionately present or absent in certain industries (e.g. technology vs commodities). We do not see any impact to our opportunity set.

How have your philosophy and processes developed over the years?

GMO was a pioneer in quantitative investing, including creating a ‘quality factor’ in the 1980’s. I joined GMO with a science and engineering background, and worked initially as a quant. But over time those techniques have become more commoditized, while traditional long horizon fundamental investing has fallen from favour. Thus, we see our path to differentiation as being to emphasize more the fundamental analysis building on top of a quantitative base.

When running a screen over the market, what are some of the attributes that you screen for/against?

We still see value in quantitative screening to cover a broad universe and to not overlook slowly developing trends. Our screening is based on historically high and consistent levels of return on capital and strong balance sheets. Those metrics identify companies that have strong market positions since competitors have not been able to come in and compete away the profitability. We avoid the opposite which suggest a commoditized or risky business.

What might make you overrule the results of your screen?

Our process affords us the flexibility to supplement the results of our proprietary quantitative screen with ideas drawn from members of the team. Typically, these are companies that haven’t made it past our quantitative screen due to some limitation in the data, for instance an IPO for a business with a relatively shorter history, or a company that has a unique business structure that isn’t fully captured by our screen. For example, we invested in one company that has been operating for over 100 years, but only recently went public.

Lyft is another example of this pragmatism in practice. Lyft holds a strong #2 position in the U.S. rideshare market behind Uber, but without the aggression of its larger peer in terms of regulation, geography, and sheer range of business models. Lyft ticks three boxes for us from a quality fundamentals perspective. First, it has an “identifiable high return asset” in the potential for attractive unit economics in the North American ridesharing duopoly. Second, we believe it has “relevance,” as our analysis suggests that the rideshare market is still quite immature, anchored by a relatively youthful clientele in large urban centres. Third, we believe that management has shown signs of “capital discipline,” having swerved dogfights with Uber outside of their key duopoly (there are no autonomous aero taxis in the works as far as we know) and is sufficiently funded to mature into a profitable piece of the transport sector.

Could you share an example of a company that you consider to be of outstanding quality?

Texas Instruments is one such example. They score well on all our quantitative metrics. They are in an industry (analog semiconductors) where there is product differentiation and long product lives. Secular drivers are in place to drive growth for years to come. TI has the largest scale, which lead to cost advantages both on manufacturing and distribution. And the management team is ruthlessly focused on capital allocation and shareholder return. Our research process involved learning about the industry dynamics from technical experts, formulating a view as to the company’s financial position, and multiple meetings with the management team including site visits.

Learn more

The GMO Quality Trust invests primarily in companies with established track records of historical profitability and strong fundamentals, that are able to outgrow the average company over time and are therefore worth a premium price. For further insights, please visit their website.

Tom will also be hosting an upcoming webinar on 5th March 2021 at 12pm where he will outline several companies that exhibit Quality attributes and offer compelling value. To register your details, use the contact form below.