Smart beta, an investment approach that combines aspects of active and passive investing, has become an increasingly popular option for asset owners around the world. In Australia, many of the exchange-traded funds (ETFs) on the ASX are now smart beta.
Proponents of smart beta strategies argue that they provide exposure to the best of both active and passive worlds – offering factors which have explained historic ‘excess’ returns at a cheaper fee compared to their active counterparts. Popular factors are typically size, value, momentum, low volatility and, importantly, quality.
What is quality anyway?
One person’s definition of quality can vary from that of the next person.
The MSCI Asia ex Japan Quality Index, for example, defines quality as a company with high returns on equity, low levels of debt and low levels of earnings variability.
I would argue this is not quality investing but rather ‘high return on equity, low debt and low earnings volatility’ investing. This is a mere subset of quality. Instead, at Stewart Investors, we look for quality in terms of people, franchise, financials and sustainability.
The quality factor portfolios that come under the banner of smart beta have a high chance of owning the quality companies of yesterday. Lacking any scepticism of the fundamentals, and with eyes firmly fixed on the rear-view mirror, they assume that historically attractive returns on assets will be translated into similar returns on future investments.
Other than (historic) consistency of earnings growth, there is no insight similar to what we would look for in quality of earnings such as: Are earnings being turned into cash or, even better, free cash flow? Are high returns the result of underinvestment in the business or a durable competitive advantage? Have they proven themselves resilient through times of stress? What are the trends driving growth and are they sustainable?
We do not own a number of the largest companies in the MSCI Asia ex Japan Quality Index, either due to sustainability headwinds facing earnings (tobacco and fast food franchises) or the hit-driven nature of their businesses (online games).
Viewing quality through a purely quantitative lens will also miss those companies investing in long-term capabilities at the expense of short-term profitability. Such companies, when operated by competent management teams who are owners, or at least think like owners, have been lucrative long-term holdings for clients. These management teams tend to be more interested in the long-term creation of wealth rather than satisfying value-destroying distractions like quarterly expectations or reducing the volatility of earnings.
This ability to think and act like an owner is one factor that our qualitative philosophy emphasises. Gaining comfort in the stewardship and thought process of the allocator of a company’s capital is very difficult to distil into an algorithm, as is collecting evidence that a company has cultivated a time horizon and culture capable of leveraging and preserving the strength of a franchise, a characteristic central to incorporating sustainability challenges into their thinking.
Trust for the long-term
Although sounding simple, owning a company for the long-term is not easy. Constant news flow and short-term volatility in share prices conspire to pull on many behavioural flaws. Persevering through these shorter term pressures requires values that a smart beta strategy cannot offer: patience, scepticism and trust.
Trust is a critical factor when investing clients’ capital. We must believe that the people at the company are suitably aligned with our time horizon, values and objectives – that they will not expropriate our clients’ capital, either through malicious behaviour or incompetent capital allocation. Studying and understanding the decisions and outcomes that have been made in the past, in the good times and more crucially the bad, increases our ability to trust in the decisions they will make in the future.
Why is this important? The longer a company is held, the more important the quality of people becomes. Over short time periods, market noise dominates returns, while over longer periods, the resilience of the business, return on investment and earnings growth drive returns – outcomes of quality decision-making. In contrast, I believe investing alongside poor quality people is the surest way to destroy capital permanently and will sell our position if trust has been lost, even if the company is earning high returns on equity, has low levels of debt and high historic earnings growth.
As patience is the capacity to delay reward, it requires that you believe there is something worth holding out for. For an investor, being able to stay invested through the tough as well as the good times, is key to the long-term compounding of capital. A lack of patience also tends to lead to chasing ‘game-changing’ companies of the hour. Owning these companies provides the sense of security that comes with being part of a crowd but results in paying valuations that reflect their popularity. Such behaviour conspires to destroy capital and obstruct the power of compounding.
If the performance of a smart beta product runs into trouble, as most strategies do at some point, what is to stop the investor questioning its legitimacy, running out of patience and moving onto the next ‘winning’ factor? I believe that there is very little. It is a strategy which makes the preservation of capital even harder than it already is.
Our long-term philosophy requires clients to trust us not to deviate from identifying and owning high quality businesses run and owned by high quality people. It also requires that they trust us to act as if their money was our own.
The reciprocation of trust and patience between clients, investment team and companies held on behalf of clients, should allow us all to stay focused on what is important – the long-term preservation and growth of capital.
It is a simple notion but one that is increasingly rare today.
Douglas Ledingham is an investment analyst at Stewart Investors.