Purist approach to quality investing “well suited to current conditions and uncertain times ahead"
How our purist approach to quality helps us identify opportunities even in unexpected low-quality parts of the market.
‘Quality’ is a term and an investment approach that has been increasingly adopted by investors in recent years given the proven long-term track record of this style of investing. However, wider adoption has also led to both inconsistency and impurity in the definition of ‘quality’ being used. In particular, the lines have become blurred with growth investing, as growth has outperformed other styles in recent years.
Ninety One’s Global Franchise Strategy reflects a purer and more consistent expression of quality that is focused solely on what we believe to be attractively valued best-of-breed ‘Franchise’ companies with the following key attributes:
In this article we provide some stock examples to demonstrate how our purist quality approach leads us to favour certain stocks over others, even in seemingly similar parts of the market, and also how we can still find quality even in unexpected low-quality parts of the market. We then finish with why we maintain strong conviction in the long-term outlook for this focused investment approach.
Quality in Big Tech
We are often asked why we do not own any of the ‘FAANG’ stocks, when these companies seemingly display many of the quality attributes we seek, such as enduring competitive advantages and dominant market positions. The strength of these businesses is evident in the strength of their share prices but that does not necessarily make them right for our investment approach. We typically prefer our technology-focused businesses to have subscription rather than transaction-based revenue models, as these are more consistent, dependable and less cyclical. We also seek high and consistent conversion of profits into cash, strong balance sheets, and exemplary capital allocation. In addition, we are mindful of business tail risks such as platform obsolescence, and regulatory risks around data privacy, antitrust legislation and taxation. Finally, even the best businesses don’t make the best investment cases as valuation is also a critical consideration.
One or more of the above issues currently prevents us from allocating to any of the FAANG stocks in Global Franchise. Instead, our approach favours another Big Tech company not captured in the FAANG acronym. Recurring revenue streams from its subscription-based cloud offering; dominant market position in enterprise software with an entrenched global user base; over $50 bn of net cash on the balance sheet; and sustainable cash flow generation from its platform that can be scaled and monetised for many years to come. The company is Microsoft and the summary table (Figure 1) below highlights why we believe it stands out as the best fit for our approach in the Big Tech space:
Quality in Financials
We think it is important to delve into the specific stock exposure we hold within financials given the very distinct groups of business models that exist within this sector. We have historically avoided banks for a number of reasons. Firstly, these businesses typically exhibit low returns on capital, predominantly earning money through the spread between short-term deposit rates and longer-term loans, with equity returns magnified through leverage. With this model, exogenous forces such as interest rates and the broader health of the economy become key determinants of profitability. Differentiation in core banking is difficult to exhibit, hence the limits to supernormal profitability and more commoditised profit profiles. Insurance companies exhibit similar challenges for a quality investment process, and hence we have avoided this industry within the Global Franchise strategy.
We become more interested in businesses in the financials sector when they exhibit capital-light business models, highly differentiated competitive positions, structural tailwinds, or preferably a combination of these traits. For that reason, we have held Moody’s for many years, a dominant player in the oligopolistic market for credit ratings, where brand recognition and trust are almost insurmountable barriers to new entrants. The market for independent credit ratings has benefited from a structural tailwind since the GFC, as banks around the world have de-levered and debt financing has incrementally shifted from bank loans to capital markets.
Charles Schwab is another financial stock held in the portfolio (since 2018). We admire the customer-centric way in which Schwab manages its business. This approach, and the continuous reinvestment in the customer experience has led to significant growth, and Schwab now offers brokerage and asset management (among other investment services) to millions of customers, boasting over $7 trillion in client assets. They earn money from this system through net interest, not unlike a bank. However, Schwab benefits from a structurally lower cost of funding due to the exemplary service it offers clients, who worry little about the interest rate received on cash deposits. This allows the company to take almost no credit risk in its investment portfolio, investing the majority of its assets in government backed securities.
We admire the customer-centric way in which Schwab manages its business.
Quality in low-quality end markets
Technology, and more specifically software, is often treated as a monolith within global equity markets. Beneath these labels there exists a diverse array of business models, with varying drivers of value, and we think it is interesting to consider how specialised software players can provide attractive exposure to some end markets that themselves tend to be lower quality.
Construction for example, tends to be a cyclical industry, with both residential and commercial property cycles driven by the economic environment, financial conditions and nuanced, local supply and demand drivers within markets. These characteristics combined with largely commoditised offerings tend to make construction firms, building materials businesses and commodity players low return on capital propositions, not suitable for our quality approach.