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Financial intermediary?

Controlling volatility

Quality equities: best of both worlds

November 2016

Geetu Sharma, Senior Investment Manager

Geetu Sharma explains how quantitative and fundamental research can be combined to capture the best of both investment skills.

Can you remind us how you define Quality stocks and what your investment process is?

We define Quality companies as those with high and stable profitability, healthy balance sheets and attractive valuations. We prefer companies that have demonstrated an ability to generate attractive shareholder returns without taking undue risks. Such companies are likely to be more resilient and better prepared to face economic downturns. For instance, we avoid start-up companies that are yet to generate positive cash flows; in our view, these firms often fail to deliver on high market expectations.

We define Quality companies as those with high and stable profitability, healthy balance sheets and attractive valuations. 

We assess a company’s investment potential through a proprietary framework that focuses on four key determinants of Quality – Profitability, Prudence, Protection and Prices – or the 4Ps.1 

The 4P framework combines metrics that differentiate between a high and a low quality company. It is a systematic screening process that helps us narrow down a large universe. 

We then assess the investment potential of each company that meets our criteria using fundamental research. The result is our preferred list. 

Finally, we use a portfolio construction model to determine the weights of the stocks in the final portfolio. The aim is to diversify the portfolio as far as possible and maximise return for the given risk.

How does an investor benefit from blending quantitative and judgemental research?

In many ways, our process has parallels with free-style chess. Pioneered by grandmaster Garry Kasparov in the late 1990s, free-style chess allows participants the option to use a computer. Interestingly, the use of computers did not diminish a player's ability. Quite the opposite - it enhanced it. In fact, Norwegian grandmaster Magnus Carlsen, who became the youngest person in history to earn the No.1 ranking in 2009 at the age of 19 years, trained with a computer. In our fund, we take a similar approach of combining human skills (judgemental) with sophisticated computer models (quantitative), to harness the best of both investment worlds.

For instance, we think aggressive growth or financial leverage adds undue risks to the business, making it more vulnerable to external shocks.
RELATIVE PERFORMANCE OF COMPANIES WITH LOWER DEBT VS GLOBAL UNIVERSE
Quartiles of equally-weighted portfolios, ranked by total debt/total assets. Compared with equally-weighted basket of MSCI World index rebalanced semi-annually. From 12.1991 to 11.2012. Total return in USD, gross of fees.
RELATIVE PERFORMANCE OF COMPANIES WITH LOWER DEBT VS GLOBAL UNIVERSE
Source: Pictet Asset Management, Worldscope, Thomson Reuters Datastream
We find that mining companies tend to invest heavily at the peak of the market cycle, only to subsequently cut capital spending and sell assets at distressed prices when the cycle turns. With the help of quantitative research we have been able to validate this thesis. Indeed companies with high growth, funded by debt, tend to see more volatile swings in their stock prices and often underperform in the long run (see chart above). This was the genesis of our Prudence dimension.

How do you review the qualifying stocks to come up with a preferred list?

As we are ranking the universe of companies using our systematic framework, we sometimes come across “false” positives or negatives – stocks that have a good or bad score for what may be the wrong reasons. By applying our knowledge of companies, industries and even potential accounting inconsistencies we filter out these false signals.

By way of illustration, let us consider consumer goods company Unilever’s leverage position. Its leverage ranges from 10 to 100 per cent depending upon whether you look at market value of equity or book value. So if we were to simply follow the signal from our model, we risk overlooking what could turn out to be important signals.

This is why we also dig deep into company reports. We look at other factors such as the company’s financial flexibility and the sustainability of cash flows to determine its ability to service debt.

Similarly, dividend yield is an important metric for valuation. In the current low yield environment, companies offering high dividends are in high demand. Indeed, several energy stocks are trading at very high dividend yields, but given the pressure on oil prices, we apply an additional and more stringent assessment of dividend sustainability.

How do you ensure the 4Ps framework remains relevant in a constantly changing market environment?

Our 4Ps framework is not a static one – we constantly monitor the metrics within each category and adapt to the changing market environment. We are always asking ourselves, “We know it works today, but will it work tomorrow?” Regulations can greatly affect the profitability of a particular industry, and our judgemental analysis is essential in identifying their impact. For example, in the property sector, we are looking at different ways of analysing companies as different accounting standards – such as GAAP or IFRS – affect the value of the assets, and ultimately change return on equity. Similarly in the financial sector, a wave of new capital requirements is bringing about profound changes within the industry. We are looking for ways to enhance our framework to identify the future winners and losers in this changing landscape.