But Northern Trust assigns quality scores to stocks based on an array of measures, including a company’s ability to convert assets into sales and earnings and its ability to convert equity and invested capital into returns. Other dimensions include a company’s solvency and its ability to self-fund growth without overextending itself. “We don’t want to see balance sheets that are out of whack” or companies that are overly aggressive in capital spending and M&A.
Again, Hunstad won’t name names, but contrast the performance of a serial acquirer like AT&T that has racked up $180 billion in debt with a disciplined rival like Verizon that makes only strategic acquisitions and then pays down debt. Verizon is expected to be in a far better position when 5G is rolled out over the next five years. In the popular FANG universe, it’s clear a highflier like Netflix that must access the credit markets on a continual basis wouldn’t meet the self-funding test.
When it comes to constructing quality portfolios, two quality funds can look very different. BlackRock prefers to design factor portfolios that tend to be sector-neutral, according to Sara Shores, head of investment strategy for the firm’s factor-based strategy group. “Otherwise, you would end up with portfolios overweighted to health care and consumer staples,” she says.
Shores notes that fundamental accounting measures vary across industries and portfolios need to adjust for this. She adds that cash earnings are a more illuminating measure than accrued earnings, which can be manipulated more easily.
BlackRock also tries to ascertain where “we are in the economic regime,” Shores continues. “Our research suggests we are slowing. That kind of environment tends to favor quality. Investors are feeling fragile and looking for defensive strategies. Value tends to do well when growth is accelerating.”
Shores likes to see companies that are growing profits by investing in organic growth rather than making acquisitions.
Other quality funds favor high concentration. The GMO Quality Fund held 45% of its assets in technology stocks on November 30, according to a note its manager, Tom Hancock, sent to clients. He maintained that “a technology-heavy portfolio can still be defensive if it is comprised of the right companies that meet our quality standards and trade at reasonable valuations.”
Many advisors who follow GMO’s seven-year asset class forecasts might be surprised to learn that its “carefully constructed subset of 40 stocks” has a far better outlook than the U.S. market as a whole. Hancock says “a 5% real return for high quality stocks” is achievable for the next seven years, as he expects profit margins to be sustainable, with no multiple compression. Some of the top holdings in his high-conviction portfolio were Alphabet, Apple, Microsoft and Oracle. It also owns industrials like Honeywell, 3M and United Technologies.
It’s hard not to observe how many quality strategies hold asset-light, high-quality companies like Alphabet and Microsoft. Although Jensen Quality Growth also holds these companies, Allen Bond, the fund’s manager, notes his fund also holds United Technologies, a very capital-intensive business. “We’re a growth manager, but valuation discipline is critical,” Bond contends.
Individual securities can possess characteristics belonging to multiple factors. For example, Leah Bennett, president of Westwood Trust Co., cites Public Storage as a quality value stock. With a dividend approaching 4% and its facilities filled at nearly 98% capacity, one could call it quality, value or both.