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Why you should stick with quality businesses

quality

Why you should stick with quality businesses

So far, 2016 hasn’t been an easy time for quality-oriented investors.  If you look at returns across the ASX, low quality companies, like many in the Materials and Energy sectors, have provided stellar returns, while high quality companies have delivered comparatively boring returns. Despite this, we don’t believe it’s time to abandon quality businesses.

At MIM, we have generally been pleased with our stock selection efforts, and satisfied with the way the profits of our portfolio companies have been growing, but in share price terms our portfolios have not been keeping pace with the broader market.

One of the factors that has been driving relative performance during this period has been an interesting dynamic around quality.  In particular, the market appears to have been eschewing quality in favour of… something else.

As part of our investment process we maintain a database that assigns a quality score to several hundred ASX listed businesses.  The score reflects things like: pricing power, industry structure, barriers to entry, growth potential and return on capital.  Unsurprisingly, our portfolios are tilted strongly towards those businesses with favourable quality scores.

Some analysis of the database throws up a few interesting observations.  If we rank all companies on the basis of their assessed quality score, take the best and worst 10 percent from the database and track their investment returns since the start of the year, here is what we find: the highest quality companies have delivered total investment returns averaging 7.8 per cent.  That’s obviously a satisfactory result in absolute terms over less than 8 months, and is in line with the returns we have seen from our portfolios.

However, the very lowest quality companies have delivered total investment returns averaging…

Wait for it…

75.3 per cent.

That’s a remarkable number in anyone’s language, and a dramatic outperformance over the higher quality companies.  So what gives?

In terms of composition, the high and low quality groups both include a mix of industries, but the mix is quite different.  The high quality group is largely from the Financials, Healthcare and Information Technology sectors, while the low quality group has a strong representation from Materials and Energy companies.

This latter group has benefitted from a turnaround in commodity prices, and if you consider the case of a high cost/low margin producer with a significant amount of leverage, an improvement in commodity prices can easily swing cash flows and profits from the negative to the positive.  A business whose equity was worth close to zero a short time ago now has a meaningful amount of market value ascribed to it, resulting in very large proportional gains.  Smaller, volatile businesses like this appear to be a significant contributor to the extraordinary numbers we reported above.

Of course, this is not necessarily something that can persist indefinitely.  A low quality business of this type is very much at the mercy of future commodity price changes, and can lose value as quickly as it can gain it.

So, high quality businesses have delivered some solid, but comparatively boring returns so far in 2016.  We note the alluring sizzle offered by other parts of the market, but that’s a BBQ that we won’t be joining any time soon.

Tim joined Montgomery as Head of Research and Portfolio Manager of The Montgomery Fund in July 2012. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Before joining Gresham Partners, Tim worked for McKinsey & Company for four years, where he was involved in strategic consulting in both Australia and Denmark.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

6 Comments

  1. Hi Tim, a very interesting article ,I just wonder how many of those lower quality stocks would be still around today at all if we had realistic interest rates instead of the very cheap cost of capital that exists today ,I’d say many of them would be long dead and buried resulting in large capital losses for investors and definitely not %70 + gains .As an investor in your fund im glad and very much impressed with the gains you have delivered and specially since it has been achieved with very high levels of cash holdings ,I feel very comfortable being invested in Montgomery funds .bring on Armageddon .

  2. Excellent article showing why it is important to stick to your process.
    I screen stocks on lessons learnt from RM and others, and my results are in line with your 2016 performance…but 2015 performance makes one’s eyes water as those screens caught BKL, DMP etc, so to match general market this year is great
    Love your work

  3. It all comes down to how you want to play the “game”. Trading or investing or a bit of both.

  4. Stephen Reeves-Williams
    :

    Tim, is it worth considering how the fund has been protected on the downside in this type of article? For example whilst we may not have captured the full upside momentum, when there’s a down turn, has the fund incurred less of a loss with its higher quality businesses over those considered lower quality?

    • Hi Stephen, what a terrific question. You’ll be pleased to know that since inception of The Montgomery Fund, in any month the market has risen the fund has captured 96% of the move. In any month the market has fallen the fund has captured just 47% of the down move.

  5. That’s staggering. A 75% rise. I’d guess that a lot of punters will get sucked in to those seductive numbers but you wouldn’t want to be on the receiving end when the worm turns.

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