Why ‘QARP’ is the new ‘Value’

Ned Bell

Bell Asset Management

Global equities represent a good way to add portfolio diversity and gain access to global companies. Over the past ten years global equities have performed well for investors, but in light of the rising volatility in markets, many investors are asking themselves how their global equities exposure will perform in uncertain times and what can they do to protect on the downside?

Where to find downside protection?

While asset allocators adopt different approaches to ‘style’ mix in their global equities portfolios, it’s fair to say that many would have some exposure to the Value and Growth style extremes. The hope being that Growth plays the upside capture role and Value plays the risk protection role.

A distinct alternative to Value for the downside protection role in a style neutral portfolio is Quality at a Reasonable Price or QARP. As the name suggests, QARP provides exposure to quality companies at a reasonable price, that is, investing in high quality businesses while not overpaying for them − an investment style that should help avoid the Value traps.

It is our experience and belief that high quality businesses with low levels of debt have the potential not only to provide superior risk-adjusted returns, but they may also exhibit defensive characteristics in times of market volatility.

Typically, the characteristics of companies identified using a QARP approach exhibit far superior profitability and financial strength metrics with comparable valuation attributes to the MSCI World Index.

Avoiding the value traps

Value portfolios often come with meaningful fundamental risk. Many stocks are cheap for a reason and may seem like a bargain, however further research and modelling is required to understand a company and the industry it operates in. For example, a company that currently looks attractive from a valuation perspective, may be facing fierce competition or operating in a declining industry. While short term trends can be misleading, a well diversified portfolio of stocks and styles can help to overcome some of the risks involved in Value stocks.

QARP Test: Smart science that improves lives

World leading manufacturer of oleochemicals (i.e. chemicals made from plant or animal based oils or fats) Croda, is innovating through the development of niche alternatives to fossil fuel based products, that are both environmentally friendly and sustainable.

Croda has a global manufacturing and R&D footprint serving over 1,700 customers across the consumer, life sciences and industrial sectors. This company passes our stock selection investment criteria including robust ESG and has returned 16.4% p.a. from 22 May 2012 to 30 September 2019 in the portfolio. It has a strong management team that has been at the helm of the company’s growth, improving margins and return on capital by more than 15% since 2010. We like it financially as it has low levels of debt, reinvests in capital expenditure and M&A activity and pays a progressive dividend – where its dividend has risen with its earnings per share. The stock has maintained a AAA ESG rating by MSCI since 2016 and has grown EPS from £1.25 at the time of purchase (May 2012) to £1.91 in 2019.

Earlier this year, the company was named the Chemical Industry Association (CIA) Company of the Year, as well as winning the CIA Environmental Leadership Award.

The downside protection role of QARP

As we look across the global equity landscape, the overall risk environment has escalated quite meaningfully. Against this backdrop, there is an argument that Growth’s stellar run in recent years is running out of steam and the risk of valuation de-rating is meaningful. There is also an equally worrisome argument around earnings risk/sensitivity with the Value cohort. Such global companies often come with a combination of elevated regulatory risk, capital intensity, little pricing power, leverage and economically sensitive earnings.

If we look at downside protection in portfolios, recent history has demonstrated that Value investing, by and large, has not achieved its objective of protecting capital in negative markets. As illustrated in the table below, comparing the MSCI World Value Index vs MSCI World Index, the three negative years over the last 10 calendar years have been in 2011, 2015 and 2018, and the excess return or value-add from Value has been poor at best.

Source: eVestment. Data based on calendar years.

While it should not be discounted that Value may well have a rebound at some point, we believe it is important for investors to consider alternatives such, as QARP, particularly for the downside protection role in a well-diversified portfolio.Source: eVestment. Data based on calendar years.

In those same years when Value did poorly, a global equities strategy employing QARP would have outperformed the MSCI World Value Index and MSCI World Index by an average of 7.69% and 5.65% respectively, while exhibiting lower volatility than the respective indices over the short, medium and long-term.

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Ned Bell
CIO and Co-Portfolio Manager
Bell Asset Management

Ned Bell is Chief Investment Officer and Portfolio Manager at Bell Asset Management (“BAM”) and is also a shareholder. Ned has 20 years of experience in the investment management industry in the US and in Australia managing retail and...

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