We’re led to believe that the higher the risk, the higher the return. But that’s not actually how share markets have worked, and no one can explain why.

Article by Jonathan Shapiro, Senior Reporter, www.afr.com


Any stock picker that has been handicapped by an actual education in finance will know all about the efficient market hypothesis – that a security’s price reflects all known information at any given point.

Beating the market is grounded in skill, not luck.

But this central tenet of academic finance has not prevented the enrichment of an entire generation of fund managers that, in aggregate, have only served to undermine this theory.

There may be one market-beating strategy that does work. And it sounds so simple and grounded in so much common sense that it’s only natural to dismiss its efficacy – to buy quality companies.

In an investment sense, quality companies are those with reliable earnings, high returns on equity and low levels of debt.

Of course, we want to own these stocks. But if the market is truly efficient, the price should be sufficiently expensive to the point where any further appreciation is largely guesswork.

But quality keeps on winning. In 2023, MSCI’s quality index beat its standard index and has done so by a comfortable margin since its inception in 1994. Meanwhile, quality-focused funds have either beaten the market or kept pace when others have eaten the dust of the so-called magnificent seven.

The persistence of quality has investors, and academics, scratching their heads and sharpening their pencils.

“French and Fama and the boys completely missed this back in the day,” GMO’s Jeremy Grantham told an investment conference in Sydney last year, referring to Kenneth French and Eugene Fama, the academic high priests of market inefficiencies.

GMO wrote two papers on the quality factor last year, exploring whether it works, how and why. One described it as “the weirdest market inefficiency of all”.

If things worked as they should, low-quality stocks should give investors a higher return for the extra risk they’re taking relative to reliable solid quality stocks. But they don’t.

The fact that the highest quality quartile of the market has outperformed the lowest quality quartile by 4 per year is utterly counterintuitive, astonishing, and demands to be incorporated when building sensible equity portfolios, GMO’s Ben Inker wrote.

GMO determined that quality has worked well over longer time periods, in all sizes, and there’s even evidence of it working in the bond market. Higher rated BB bonds have done better for investors compared to riskier CCC bonds.

So, buying quality seems to work, but the intriguing quest is to understand the cause. Why do optically expensive quality companies turn out, actually, to be cheap?

GMO’s Inker has no satisfying answers. One theory is that since we’re living in age of monopolies where cartels aren’t busted up like they were in the days of Rockefeller, the reign of quality companies is extended. But that doesn’t explain the fact that quality stocks do better in small caps as well as large caps.

It could be that quality companies are more predominant in better, sounder industries such as tech and healthcare, but then again, the quality phenomenon is particularly strong as a subset of cyclical stocks.

So what’s stopping investors from buying quality and making super returns? Active managers would rather own a low-quality stock with room to run than a high quality stock that may be safer but is less likely to deliver outperformance in the short run.

Overpaying for ‘lottery tickets’

Quality tends to underperform when markets go up, and markets tend to go up more than down, so active managers play the odds by favouring the cheaper stuff.

He describes this as “a lottery ticket payoff pattern that people consistently overpay for”.

To try to further understand the quality anomaly we poured through investor letters and reached out to fund managers that invest with a quality bias. GCQ Funds, which invests in a concentrated portfolio of quality stocks (including index owner MSCI) took a stab at explaining the anomaly in its January letter. It believes the cause is sell - side analyst conservatism – not something they’re known for.

The fund cites Mastercard, which back in 2008 held a similarly dominant market position while clocking revenue growth in the mid-teens to low-20s. But analyst forecasts undercooked the prospect that this would be maintained.

“We believe there is an institutional reluctance to publish valuations far above the current market price, and so consensus estimates of the day invariably assumed that Mastercard’s mid-teens annual revenue growth would quickly decline, or fade, after only a few years, back closer to GDP growth.”

Constantia Investments’ Etienne Vlok cited French mathematician Blaise Pascal who once said, “all of humanity’s problems stem from man’s inability to sit quietly in a room” to explain why the anomaly persists even though it’s known to all.

“To be more blunt, it exists because people are impatient and overweight the near term at the expense of under-weighting the value of long-term compounding.”

George Hadjia of Bristlemoon also surmised that a tendency of investors to “taper down their growth forecasts in a mechanical fashion” has led to consistent underestimations of true value that is further enhanced by business opportunities in the future. A case in point here is food giant Nestle’s investment Nespresso, and Amazon’s push into digital advertising.

But investing in quality companies isn’t that easy.

In Australia, the issue for large cap investors is that there simply isn’t the depth of quality stocks to gain a reliable exposure to this attribute.

A set-and-forget approach doesn’t always work, and the quality league tables can change dramatically.

The largest weights in MSCI’s quality index today are Nvidia, Microsoft, Apple, Meta and Lily.

A decade ago, Apple and Microsoft were joined by Exxon, J&J and Roche. Twenty years ago, Exxon and J&J were joined by IBM, Proctor & Gamble and GSK while 30 years ago none of AT&T, Coca-Cola, Phillip Morris and Walmart survived in the top five a decade later.

Cautionary tale

Nick Ferres of Vantage Point calls out the cautionary tale of Cisco, a quality company that has delivered 30 per cent return on equity but has failed to recapture its 2000 high.

“Quality and growth are important but the price you pay still matters for your future return.”

And quality companies can lose their lustre. Aoris chief investment officer Stephen Arnold told investors that two stocks the fund once owned – Nike and ADP – faced stiffer competition than initially foreseen which led him to exit.

“We always want to balance being long-term owners of successful businesses with vigilance in recognising lasting shifts in the competitive landscape,” he wrote in the fund’s annual letter.

Arnold added another salient point on market efficiency in his update. There was “no evidence that large, well-known companies are any more accurately priced than small ones”.

Microsoft, he said was “grossly mispriced” in mid-2022 while the demise of IBM, Citigroup, AT&T, Ford, and Hewlett-Packard was not reflected in the extensive research and analysis conducted by the market over the last decade.

That should give comfort to stock pickers that their quest is not futile, and that inefficiencies persist. Now they just have to pick the right stocks.