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The Hows and Whys of Quality Investing

The Hows and Whys of Quality Investing

Contents
November 6, 2020

Historically, investing in quality companies is an approach that has enabled investors to earn strong risk-adjusted returns. 

Quality investing has worked overtime because high-quality stocks tend to experience lower volatility and greater strength and consistency in returns over a full market cycle, including during the downturns.

The Quality Cycle 

High-quality companies show outperformance and more consistent returns over time. However, their prices follow a pattern related to the overall market cycle, which is sometimes referred to as the “quality cycle.” Low-quality and high-quality stocks typically do not move together. 

In fact, there are periods when high-quality businesses experience underperformance relative to lower quality companies, especially at the beginning of bull market cycles. Lower-quality companies tend to rebound more sharply from recessions than the high-quality segment. This is because, due to a greater reliance on credit, they gain more from improving economic conditions and, particularly, from an improving credit market.  

However, at KAR, we believe that markets are too complex and dynamic for anyone to reliably predict future price movements and thereby time the market as it transitions from a low-quality bias to a high-quality bias, and vice versa. When investing for the long-term, high-quality stocks are an important ballast for an investment portfolio due to their financial stability and greater propensity for growth across varying macroeconomic environments.

The Characteristics of Quality 

A high-quality approach seeks to identify companies with outstanding financial and business characteristics, including soft (e.g., competitive advantage or management competence) and hard criteria (e.g., high returns on capital or balance-sheet health). Our goal is to create a portfolio of what we believe are the highest-quality businesses by following an in-depth research process.

We look for companies with:

  • Effective competitive barriers. Also known as a “business moat,” these characteristics set a company apart in its industry and give it a durable competitive advantage. 
  • Prudent management teams. We look for management that sticks to the company’s core competencies, cultivates the business’ competitive advantage, and allocates capital in a shareholder-friendly manner. 
  • Steady and consistent earnings growth. Forecasting is more predictable, and risk is lower.
  • Strong free cash flow and above-average returns on capital. These give companies a stronger ability to face and overcome unexpected challenges.

For additional information about quality investing, read our detailed White Paper and consult with a Kayne Anderson Rudnick representative today.

DISCLOSURE

This report is based on the assumptions and analysis made and believed to be reasonable by Kayne Anderson Rudnick (“KAR”). However, no assurance can be given that KAR’s opinions or expectations will be correct. This report is intended for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. Past performance is no guarantee of future results.

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