The Search for Quality Can Be Worth the Extra Effort

October 2012

Fads come and go. Bubbles inflate and burst. But what becomes of quality?

"That rarely goes out of style," says Matt Peron, senior vice president and head of Active Equity Management at Northern Trust. "When you're buying stocks, it helps to focus on owning high-quality securities."

According to Peron, the reason is straightforward: Companies with sound finances, top products and disciplined managements may have a better chance to prosper over the long haul.

That sturdiness also could help them hold up better during economic storms — an important factor in the turbulent post-financial crisis environment.

"High-quality stocks tend to be less volatile," Peron notes.

Even for investors with long time horizons, mitigating volatility can be important. In part, that's because a smoother ride makes it more likely that they'll stick with their financial plans when the ride gets bumpy.

Uphill climb
But Peron says there are demonstrable benefits to limiting volatility as well.

"Equal-sized gains and losses don't offset," he says. "If a stock falls 50% and then rises 50%, it's not back to even. It's still down 25%."

The odd mathematics of investing might explain why, contrary to conventional thinking, low-volatility stocks often outperform their jumpier counterparts. In theory, higher-risk stocks should reward investors with higher returns. In reality, though, it's often quite the opposite.

One study found that the most volatile quintile of stocks in the Russell 3000 Index under performed stocks in the lowest quintile of volatility by nearly 12 percentage points per year between January 1973 and June 2012.1

Explanations for the disparity in returns are complex and varied, but one possibility is that investors view low-priced, high-volatility stocks as a kind of lottery ticket. Heightened demand pushes up the stock price, thus limiting its upside potential.2

Not that quality is always a winning ticket, either, especially over short periods. Since most stocks move in the same direction — if not by the same amount — even high-quality securities decline during bear markets.

Higher-quality stocks also tend to underperform their riskier counterparts on those occasions when investors embrace the "risk-on" mindset. That's happened periodically since the Great Recession ended in 2009.

When the animal spirits take hold, those lottery tickets can look mighty tempting.

Dog day afternoon
Lower-rated debt securities typically lead when the economy rebounds from recession as well, since they've usually been beaten down most during the previous bear market.

So for all the potential long-term benefits, owning quality isn't a one-way street.

"Quality is not a silver bullet against volatility and loss," says Scott Warner, vice president and head of Fixed Income Product Management at Northern Trust.

Over time, though, Warner thinks that a strong focus on buying quality is the prudent approach.

Peron notes that emphasizing quality has been "a differentiating factor" of Northern Trust for more than 40 years.

"We're a conservative Midwest-based asset manager that places a high priority on risk management," adds Warner. "Our clients want a return on their money and a return of their money. That requires us to develop and employ proprietary methodologies that identify quality companies and securities."

This begs the question: How is quality measured in a stock or bond?

Quantitative measures
For equities, there are several key metrics to consider. According to Peron, a company's ability to pay a cash dividend says much about its financial strength.

"Unlike the Federal Reserve, companies can't print money," he says. "They pay dividends out of cash they have on hand." However, companies can borrow to pay shareholders, so the leverage aspect has to be monitored closely.

Still, companies that regularly increase their dividends have outperformed the overall U.S. equity market over the last one-, three-, and five-year periods.3

Another study found that shares of the highest 50% of dividend payers returned 13.5% over the last three decades, compared with 11.3% for the lowest 50%, and just 8.1% for non-payers.4

Whether the corporate cash is paid out as a dividend, used to fund internal growth, make acquisitions, or reduce leverage, Peron says that a company's ability to generate cash is by itself a measure of quality. In fact, shares of the top quintile of U.S. companies (as ranked by cash flow) gained 15.9% per year since 1981 — six times more than those in the bottom quintile.5

Now, do it again
Consistency of earnings is another way to quantify quality. While profits of even the best companies usually rise and fall as economic growth waxes and wanes, shares of businesses that post the steadiest profits often can be less volatile.

"Investors are more likely to stay with a company whose earnings don't disappear every time the economy hits the skids," Peron says.

A company's return on assets (ROA) also says much about its quality as an investment. Since the early 1980s, stocks ranked in the top quintile for ROA have generated a total return of 12.3% per year, double the 6.1% gain for the lowest quintile.6

Finally, Peron says that companies carrying high debt loads generally won't earn the quality label from Northern Trust either, even if all the other metrics qualify it as such.

"The 'survivability' factor trumps all the others, and high leverage puts a company at risk of failure during periods of economic weakness," he says. "Like now."

The human touch
Even after all the quantitative data are crunched and evaluated, however, there's still one crucial piece of the quality puzzle that's missing.

"Ultimately, the success of a business boils down to the expertise and discipline of the people running it," Peron says. "The management team is crucial to establishing and maintaining a quality company. It really does start at the top."

For that reason, Peron says that Northern's fund managers make a point of getting to know CEOs and other top officials.

"The human factor is subjective, but getting it right is absolutely critical," Peron says. "You can't have a quality company without a quality management team."

He adds that taking the true measure of a management team requires years of experience. After all, it's in the best interest of corporate officers to portray their business in the best possible light.

"Northern Trust's fund managers are trained to evaluate a company's leadership personnel," he says. "Whether you're assessing the quality of a company subjectively, fundamentally or quantitatively, it takes experience to interpret the information."

Ratings errors
For fixed-income investors, the global financial crisis exposed the dangers of relying exclusively on credit agency ratings to determine an issue's quality. Many bonds that were considered top credits before the sub-prime bubble burst suffered severe ratings downgrades, sending their prices tumbling.

"The quality of a security can't be determined solely by its credit rating," says Warner. "Ratings do change, and frequently after the fact." Of course, that could be too late to avoid painful losses.

Warner says that Northern Trust's fixed-income fund managers and research team undertake exhaustive, proprietary credit analysis to head off such pitfalls. Their work involves examining every aspect of a bond's covenant and coverage ratios, the industry group or sector in which it operates, as well as the management issues noted earlier.

"Often, we'll detect slippage — or improvement — in an issuer's credit profile well before the ratings agencies or the Street picks up on it," he says. "Proprietary research is critical to maintaining quality and a margin of safety in a bond portfolio."

Cliff watching
Warner says that serious challenges faced by the global economy in the months ahead make maintaining a quality bias as important now as ever. The eurozone crisis, a stubborn growth slowdown in China, and the so-called fiscal cliff in the United States all might cause volatility to spike in the months to come.

Those concerns are in addition to the chronic unemployment and economic torpor that typically lingers long after the acute phase of a financial crisis has passed.

"As people retrench and pay down their debts, they have less money to spend," Warner says. "And consumers account for more than two-thirds of the economy."

Notably, however, Americans appear to have journeyed quite a ways down Deleveraging Lane. Outstanding credit card balances are the lowest in 10 years and have tumbled almost 23% from the 2008 peak.7

On the corporate side, Warner notes that many quality U.S. businesses are flush with cash and are ready to spend as soon as the economic and political outlooks become clearer.

So the financial world isn't coming to an end. History shows that the global economy eventually adapts to even dire shocks.

Some companies stand to inherit that changed economic landscape — and be all the better for it — since some of their lower-quality competition will have vanished.

"The best-positioned survivors of this long, tough period will be high-quality companies," Peron says.

And, he believes, the investors who own them.

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed-income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.

Small Cap Risk: Small-capitalization funds typically carry additional risks since smaller companies generally have a higher risk of failure. Their stocks are subject to a greater degree of volatility, trade in lower volume and may be less liquid.

Tax-Free/AMT Risk: Tax-exempt funds’ income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.

Value Risk: Value-based investments are subject to the risk that the broad market may not recognize their intrinsic value.

Return on Assets (ROA) is an indicator of a corporation’s profitability; it is determined by dividing annual net income by total assets.

Aiming High

Boring is Beautiful

1 Northern Trust Research, BARRA

2 Barberis, Tod and Ming Huang. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," 2008

3 S&P Dow Jones Indices

4 Ned Davis Research

5 Ned Davis Research

6 Ned Davis Research

7 "Flexible trend that cooled America's plastic passion." Gillian Tett. The Financial Times. Sep. 7, 2012

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