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Quality as a holistic investment concept

FONDSNET | May 2022
There are a handful of systematic investment concepts that have become established over the past few decades and have a proven independent performance and risk character. The oldest two are Value and Growth, but they also include Size (i.e., a focus on small-capitalization companies), Momentum, and certainly since the financial crisis, Quality. Hérens Quality Asset Management has been one of the pioneers of international Quality investments since 2003.

A systematic investment process is crucial

An established investment concept is based on clear investment criteria with the result that the performance statistically has an independent performance and risk character. In the case of attractively valued quality stocks, the focus is on clear business and valuation criteria. All companies of the investment universe (e.g. global MSCI World Index), respectively their shares, are segmented and analyzed according to the same criteria. A quantitative segmentation of the investment universe forms the basis for the pre-selection. However, it is of utmost importance to complement the quantitative segmentation with a qualitative analysis in order to ensure a comprehensive picture of the companies and investment candidates. In this context, clear specifications must be made regarding the research instruments used and the assessment of the results. This is the only way to ensure that the company analysis is as objective as possible. The investment decision should also merely ensure that the analysis has been carried out on the basis of the specifications. After all, if a company meets all the quality and valuation criteria, there is nothing per se to prevent it from being included in the portfolio. Of course, the same applies on the sell side. The result of this procedure is an attractively valued quality portfolio. Such a portfolio contains companies such as Alphabet, which have an extremely solid financial structure (see HQAM Financial Conditions Check (FCC)), a proven management team, an attractive market positioning with innovative products and an attractive valuation. The fact that not every sector produces the same number of quality companies, and some at times none at all, is obvious from a consistent, systematic analysis. A quality portfolio also cannot outperform in every market phase, otherwise the premise of objective and uniform criteria would have to be broken. However, focusing on attractively valued quality companies over the medium to long term is worthwhile, as can be shown by a systematic and risk-adjusted excess return (alpha).

Figure 1: Alphabet

Green: Our defined standard for a Quality Company is exceeded; White: Our defined standard for a Quality Company is achieved; Red: Our defined standard for a Quality Company is not achieved. Source: Hérens

Quality and ESG go hand in hand

Sustainable investing is on everyone’s lips and has become a standard for both institutional and private clients. One challenge is that, apart from rough but recognized exclusion criteria, there are hardly any uniformly defined criteria. This is a challenge for analysts and investors as well as for companies, which have to align themselves with different reporting needs depending on the region. Business economics provides such a value framework, which also includes universal criteria. But what is the connection between business administration and sustainability? In a narrow sense, sustainability, according to the Duden dictionary, means “long-lasting effect”-or, to put it another way, it means consistency. Companies that manage to be solid – or consistent – over a longer period of time due to their business model, their management and, as a result, their financial strength, are sustainable companies from a business management perspective. These quality companies use the input factors (personnel, capital, energy and other resources) “economically” in order to achieve the best possible consistent and high returns. In order to achieve this, there are of course other aspects involved. Management in particular is of central importance here. It is not for nothing that the saying goes: “The fish always stinks from the head”. But the management team also needs sufficient time to implement the ESG goals or principles that have been set. And here the circle to sustainability closes again. If a company has business problems, they are given top priority. If management fails to make improvements, it is ousted. This is often associated with changes in the ESG strategy. Experience shows that a company that is not sustainable from a business point of view cannot be sustainable for the system as a whole. If a company is subjected to a deep sustainability analysis, it is found that, as a rule, business sustainability is a necessary prerequisite for ESG compatibility. Of course, other criteria in addition to management – some of them sector-specific – must be consulted for the ESG assessment of a company. However, it helps if uniform standards – such as business management or quality – are used to create an objective basis for assessing a company.

It pays to focus

A quality portfolio focuses on the best companies in the investment universe in terms of business management and at the same time attractively valued. This corresponds to a small part of the investment universe of approximately five to ten percent. To accentuate this rigorous approach, HQAM launched the “Global Quality Top Portfolios” in 2014 and the “Global Quality Top 15 Fund” in September 2019. The launch of the “Quality Top Portfolios” proves that the better the business quality and the more attractive the valuation of a company, the more attractive the performance and risk character.

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