Quest Equities active quant defensive preserving capital

Traditionally, investing in defensive equities meant focusing on companies with very specific attributes, such as those whose shares exhibit low volatility or that pay higher-than-average dividends. But single factor strategies can be vulnerable to shifts in the economic and financial cycle. Some can become crowded, expensive investments. Others are vulnerable to sudden changes in macroeconomic conditions, such as higher interest rates.

Recognising these problems, we have developed a proprietary multi-dimensional framework that focuses on four key determinants of defensiveness – profitability, prudence, protection and price – what we call our “4P” framework. It provides a lens through which we identify companies that satisfy our comprehensive defensive criteria out of a vast universe.

4P, a multi-dimensional framework

The Profitability score helps us gauge a business's strengths and competitive advantage. Companies that rank highly on this measure have steady earnings growth, low operational leverage and high cash generation. We find that companies with a strong track record of profitability tend to have more reliable and predictable earnings than firms whose stock valuations are in part based on lofty expectations for profit growth.

Prudence is our gauge for assessing a company’s operational and financial risks. Prudent companies have a lower risk of default and expand their business organically. We invest in businesses that can create and preserve shareholder value by pursuing manageable growth and maintaining a sound financial profile. We measure this by looking at the nature and stability of the company’s cash flows relative to its financial commitments, including interest, dividend or capital spending.

We integrate environmental, social and governance (ESG) aspects in the entire research and investment process with a view to enhance returns. It also serves as an additional layer of prudence.

With the Protection metric we scrutinise how a company behaves over the course of the economic cycle in order to monitor systematic or firm-specific risks. We are looking for companies that have sustainable business models and whose prospects are insensitive to shifts in economic cycles. At the same time, we also analyse a stock’s volatility and its correlation with other equities to understand how it might affect the risk-return profile of the overall portfolio.

Finally, we don’t want to overpay for our investments. Therefore, our Price screen incorporates several reliable valuation models that help us identify the most attractively-priced stocks. Without this screen, portfolio managers could overlook promising investments or choose stocks that risk a capital loss.

The 4P framework is the cornerstone of our investment process. We combine the 4P-based systematic screening with a bottom-up fundamental analysis to identify the best investment ideas and build a portfolio of around 150 companies.

As a result of the 4P approach, our portfolio has variable factor and style exposures, encompassing large cap, quality, value and minimum volatility stocks.

Our starting point is to evenly weight all the 4Ps when we screen stocks. But we make active and tactical weighting changes, based on our analysis of the momentum and valuation of each P, judged against our assessment of current and future macroeconomic and market conditions. We believe this dynamic adjustment protects investors from being over- or under-exposed to any one defensive factor. This, in turn, helps maximise returns.

Here’s an example. In the run up to the British referendum on the European Union membership in June 2016, stock markets were jittery. Investors were largely eschewing higher-growth equities in favour of more defensive sectors such as utilities.

As a consequence, stocks that scored best on Protection in our framework saw an exceptionally strong pre-Brexit rally – so strong, in fact, that they quickly became among the most expensive equities investors could buy. Specifically, our analysis showed that such companies’ price-to-book ratios were some 40 per cent higher than that of the average listed firm – the second biggest gap in 24 years (see chart). 

Protection goes to the extreme

Relative valuation, measured by price to book ratio, of companies that rank in the top quartile of the Protection score

To us, this was a warning sign. Our research showed that when buying Protection becomes this expensive, it can act as a drag on future returns (see chart). We therefore downgraded the Protection weighting to 15 per cent from 25, while upgrading the Price weighting to 35 per cent.

Overvaluation leads to underperformance

One-year subsequent relative performance (%) of top Protection companies based on their month-end price to book ratios relative to market average

The tactical move proved beneficial. In the second half of 2016, a pure Protection portfolio – one consisting exclusively of stocks that scored highest on this metric – would have had a negative active performance of -7.1 per cent while a pure Price portfolio would have outperformed the MSCI World index by about 8.4 per cent.

Had the 4P weighting remained static, investors may have been left overexposed to this expensive Protection element and suffered a loss, which was the case for those in most low volatility funds. For instance, the MSCI World Minimum Volatility Index lost more than 9 per cent relative to the MSCI World in the second half of 2016.

Through this dynamic weighting of the 4P framework and our bottom-up stock analysis, we aim to outperform the MSCI World index over a full market cycle – which usually lasts about five to seven years – by 3 per cent gross of fees on an annualised basis.

In the past five years, our strategy had a lower volatility than the benchmark, while its upside/downside beta was an asymmetric 90 to 73 per cent. This means that on average the strategy captured 90 per cent of a market rally, while suffering only 73 per cent of a sell-off.1

We think our Quest Global Equities strategy can be a key pillar of a global equity allocation. It also helps diversify an existing equity portfolio thanks to it distinctive return profile. 

Overcoming biases for long-term return

Behavioural biases are hard to break. Investors chase cyclical and glamourous companies which promise rapid growth, and systematically under-appreciate defensive and stable companies that are attractively-priced.

But biases can hold investors back. We think by choosing these companies with a rounded defensive profile investors can get ahead of the market and achieve sustainable return in the long term.