When Quality Pays: A Fundamental Approach to Pursuing Lower Risk and Higher Returns
PIMCO
By Chuck M. Lahr
May 7, 2012
Does buying quality pay off in the world of equity investing? Quality is a characteristic that is sometimes difficult to define for equity investors. Some will say that a stock is quality just because they own it. Others will point to the CEO being “a good guy” as the definition of a quality stock. In fact, there are fundamental factors that can be used to empirically define equity investment quality, and these factors all tend to support one overriding theme: high quality stocks tend to exhibit lower volatility or risk. And I demonstrated in a recent article that the low volatility equity anomaly has empirically shown that, in general, lower risk with equities has historically led to higher long-term returns (see Viewpoint: “Stock Volatility: Not What You Might Think,” January 2012). So we expect the connection between high quality and high returns should be quite durable, and supported by fundamental data.
What is quality?
For a purely hypothetical example, take two companies, Company A and Company B:
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Company A sells products that are always in demand and has the ability to raise its price by inflation plus 2% every year due to dominant brand and positioning within its industry. Company A also borrows only to the extent that it can retain an A-level credit rating, and it pays out a substantial amount of its free cash flow in the form of a dividend that is always supported by wide margins.
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Company B sells a commodity-like product that has sporadic demand that’s dependent upon the level of economic activity as well as upon how well its product compares against its numerous competitors, who are always innovating new products to make the older ones obsolescent. As a consequence of this cyclicality, Company B regularly swings from profit to loss. Further complicating matters, Company B takes on as much debt as it can bear without being considered a “junk” credit. It doesn’t pay dividends, which is sensible given that in many years it hasn’t generated any free cash flow.
Is there really any doubt as to which company can be considered the higher quality company? Company A produces profits consistently with less financial risk and volatility to the investor while paying a regular dividend. This is a high standard against which to compare other companies. While it’s true these companies operate in different industries, this isn’t an exercise in relative quality within an industry, it’s an absolute exercise as to which company has more quality attributes, and some industries allow for this more than others.
But quality can be specifically defined as well. Benjamin Graham’s “The Intelligent Investor” offers one example of a formulaic approach for defensive investors to define and target quality; he lists several required attributes, including leverage, profitability and dividend paying ability. Healthy financial condition is one of the requirements – specifically, long-term debt should not exceed the net current assets of a company. Also part of the formula are uninterrupted dividend payments for at least the past 20 years and positive earnings for the last five years, with at least 3% earnings-per-share (EPS) growth annually over the last 10 years. All these factors speak to persistently high margins, capital return and an attractive business. Valuation is an important component as well, of course, and Graham’s formula conducts screens for stocks with a P/E ratio less than 15.
In fact, profitability, leverage or capital return are key factors in many different methodologies that define equity investment quality (the Piotroski Score is one example; it ranks stocks on nine different fundamental criteria).
For a systematic look at quality and its historic links to performance, consider three fundamental factors that can be uniformly applied to all businesses to evaluate quality: operating margin, leverage (debt to equity ratio) and dividend yield.
Fundamental investment characteristics likely to reduce equity risk
Accepting that lower risk tends to lead to higher returns over the long term, we start by evaluating how much risk is associated with each of our three factors across individual stocks. To do this, we assemble fundamentals along with risk (as measured by standard deviation) and return output for all individual stocks with static holdings in the MSCI World Index over a ten-year period (2001–2010). Our first test is to measure the statistical significance of the relationship between each of our three fundamental factors and the volatility of the stocks (using a standard statistical tool, the F-test, to analyze the variance and determine significance – see Figure 1).
But quality can be specifically defined as well. Benjamin Graham’s “The Intelligent Investor” offers one example of a formulaic approach for defensive investors to define and target quality; he lists several required attributes, including leverage, profitability and dividend paying ability. Healthy financial condition is one of the requirements – specifically, long-term debt should not exceed the net current assets of a company. Also part of the formula are uninterrupted dividend payments for at least the past 20 years and positive earnings for the last five years, with at least 3% earnings-per-share (EPS) growth annually over the last 10 years. All these factors speak to persistently high margins, capital return and an attractive business. Valuation is an important component as well, of course, and Graham’s formula conducts screens for stocks with a P/E ratio less than 15.
In fact, profitability, leverage or capital return are key factors in many different methodologies that define equity investment quality (the Piotroski Score is one example; it ranks stocks on nine different fundamental criteria).
For a systematic look at quality and its historic links to performance, consider three fundamental factors that can be uniformly applied to all businesses to evaluate quality: operating margin, leverage (debt to equity ratio) and dividend yield.
Fundamental investment characteristics likely to reduce equity risk
Accepting that lower risk tends to lead to higher returns over the long term, we start by evaluating how much risk is associated with each of our three factors across individual stocks. To do this, we assemble fundamentals along with risk (as measured by standard deviation) and return output for all individual stocks with static holdings in the MSCI World Index over a ten-year period (2001–2010). Our first test is to measure the statistical significance of the relationship between each of our three fundamental factors and the volatility of the stocks (using a standard statistical tool, the F-test, to analyze the variance and determine significance – see Figure 1).
All three factors have a very high level of significance – i.e., a close statistical relationship – with lower risk. As would be expected, persistently high operating margins led to less equity volatility for companies within this broad equity index: Companies with the ability to pass on price pressures (pricing power) or manage their cost base, or companies within an industry that structurally leads to higher margins, tend to exhibit less volatility as they consistently produce profits.
The second factor, lower financial leverage, also led to less equity volatility. This conclusion can also be supported through regression analysis, and the correlation between debt and firm risk is a concept at the core of empirical finance. Also, many investors understand intuitively how the addition of debt to a firm’s capital structure is likely to enhance results when a firm is doing well and make results worse when the firm is doing poorly, creating a broader distribution of outcomes. This falls straight through to the bottom line in terms of EPS and cash flow and manifests in a more volatile stock price.
The third factor, higher dividend yields, also led to less equity volatility. This observation may be slightly less intuitive than the other two, but makes sense when considering some of the attributes of companies that pay attractive dividend yields. Broadly speaking, these companies are subject to the discipline of paying dividends, which focuses management on sustainability and constrains their ability to destroy returns through undisciplined capital investment. The notion of a flexible dividend payout ratio isn’t broadly accepted among investors, so these companies tend to both have a natural habitat in more stable industries and actively manage operations to ensure they can meet their capital return objectives.
But in order for this three-part analysis to be meaningful, we still have to connect all the dots. Since these fundamental attributes tend to lead to lower volatility, do they also lead to higher returns? The experience of lower risk leading to higher returns in equities seems to support this, but other factors could influence the outcome. Determining which fundamentals may lead to higher returns would give investors a useful tool for constructing portfolios. Assembling a portfolio of stocks with low historical volatility can potentially lead to higher returns, but sometimes low volatility stocks become high volatility stocks due to external or internal events; this usually portends distress and substantial capital loss. Simply screening stocks for low volatility could leave a portfolio vulnerable to this development, resulting in potential losses.
Company fundamentals tend to be more durable and long-lasting than volatility characteristics; stocks with high operating margins tend to retain them due to industry structure, for example. Hence, investing in stocks with the fundamental attributes we outlined may provide investors with a more durable form of low volatility for the long term.
But before we analyze the returns that the three fundamental factors produced historically, let’s consider the results that come solely from investing in lower volatility stocks over a ten-year period (2001–2010). The data presented in the four following charts is based upon segmenting all individual MSCI World Index constituents into deciles for their average returns and fundamental attributes.
Analysis of factors
In Figure 2, we see that lower volatility (as measured by standard deviation) led to higher returns when looking at individual stocks (grouped by deciles) from MSCI World over this time period. This seems to be a persistent and durable relationship over periods where the stock market isn’t progressing upward or downward in a straight line.
The second factor, lower financial leverage, also led to less equity volatility. This conclusion can also be supported through regression analysis, and the correlation between debt and firm risk is a concept at the core of empirical finance. Also, many investors understand intuitively how the addition of debt to a firm’s capital structure is likely to enhance results when a firm is doing well and make results worse when the firm is doing poorly, creating a broader distribution of outcomes. This falls straight through to the bottom line in terms of EPS and cash flow and manifests in a more volatile stock price.
The third factor, higher dividend yields, also led to less equity volatility. This observation may be slightly less intuitive than the other two, but makes sense when considering some of the attributes of companies that pay attractive dividend yields. Broadly speaking, these companies are subject to the discipline of paying dividends, which focuses management on sustainability and constrains their ability to destroy returns through undisciplined capital investment. The notion of a flexible dividend payout ratio isn’t broadly accepted among investors, so these companies tend to both have a natural habitat in more stable industries and actively manage operations to ensure they can meet their capital return objectives.
But in order for this three-part analysis to be meaningful, we still have to connect all the dots. Since these fundamental attributes tend to lead to lower volatility, do they also lead to higher returns? The experience of lower risk leading to higher returns in equities seems to support this, but other factors could influence the outcome. Determining which fundamentals may lead to higher returns would give investors a useful tool for constructing portfolios. Assembling a portfolio of stocks with low historical volatility can potentially lead to higher returns, but sometimes low volatility stocks become high volatility stocks due to external or internal events; this usually portends distress and substantial capital loss. Simply screening stocks for low volatility could leave a portfolio vulnerable to this development, resulting in potential losses.
Company fundamentals tend to be more durable and long-lasting than volatility characteristics; stocks with high operating margins tend to retain them due to industry structure, for example. Hence, investing in stocks with the fundamental attributes we outlined may provide investors with a more durable form of low volatility for the long term.
But before we analyze the returns that the three fundamental factors produced historically, let’s consider the results that come solely from investing in lower volatility stocks over a ten-year period (2001–2010). The data presented in the four following charts is based upon segmenting all individual MSCI World Index constituents into deciles for their average returns and fundamental attributes.
Analysis of factors
In Figure 2, we see that lower volatility (as measured by standard deviation) led to higher returns when looking at individual stocks (grouped by deciles) from MSCI World over this time period. This seems to be a persistent and durable relationship over periods where the stock market isn’t progressing upward or downward in a straight line.
To the extent that our three quality fundamental factors correlate with lower volatility, we should expect the low volatility anomaly to hold – i.e., that these quality fundamental factors may also lead to higher long-term returns. And generally this is the case. But let’s examine the returns derived from each of these three factors over a ten-year period and analyze the reasoning behind this method’s success or failure.
First, we look at financial leverage, defined as the average debt to equity ratio of an individual company. The simple rule of avoiding leveraged equity investments seems to have some value when we look at return deciles for MSCI World Index stocks (see Figure 3). Extremely high leverage often results in lower returns as it begets volatility and imparts substantial risk into the equity, leading to bankruptcy in some cases.
First, we look at financial leverage, defined as the average debt to equity ratio of an individual company. The simple rule of avoiding leveraged equity investments seems to have some value when we look at return deciles for MSCI World Index stocks (see Figure 3). Extremely high leverage often results in lower returns as it begets volatility and imparts substantial risk into the equity, leading to bankruptcy in some cases.
Second, we look at operating margin. This fundamental attribute has the highest level (99.9%) of significance with low volatility. We can see from the return deciles (see Figure 4) that it also is an indicator of the return potential of a company, as high margin companies on average produced higher returns compared with lower margin companies. The advantages that high margin companies often have in consistently producing earnings and capital seem to have a dominant effect on their return profile.
Next, we examine the relationship that dividend yield historically has with producing returns. This is another factor that typically has a high level of correlation with low volatility, and the investment advantages of capturing a high dividend over the long term are well-documented. Curiously, over the ten-year time horizon, we find that there is a relationship between higher dividends and higher returns with an exception for companies that are paying little to no dividend (see Figure 5) – some of the stocks paying little to no dividend produced substantial returns. Many of these companies were clustered in the information technology and materials sector, where either stock-specific factors or the broader secular rerating of base commodity prices drove stock appreciation. Also, keep in mind many of the biggest value destroyers over the same time period paid a dividend in many years; these value destroyers were found in the financial services sector, which typically has a higher-than-average dividend yield coupled with a lower-than-market valuation.
Still, the positive overall effects of a high dividend are seen broadly throughout the deciles. But as is often the case, an active approach with skill can lead an investor to avoid the value traps that were giving false signals (such as banks with attractive expected dividend yields) and to invest in equities with unique factors that may override a simple rule-based approach (technology stocks with strong franchises that paid no dividend).
Still, the positive overall effects of a high dividend are seen broadly throughout the deciles. But as is often the case, an active approach with skill can lead an investor to avoid the value traps that were giving false signals (such as banks with attractive expected dividend yields) and to invest in equities with unique factors that may override a simple rule-based approach (technology stocks with strong franchises that paid no dividend).
Investment conclusions
The relationships between fundamentals, volatility and expected returns have a number of consequences for investors. First, quality can be defined for equities with fundamental analysis. Second, the factors that define quality tend to lead to lower risk in individual equities. Third, as these fundamental factors in part lead to lower volatility, they may also lead to higher returns to the extent the stocks participate in the low volatility anomaly. Strategies that focus on these fundamental factors may generate more alpha due to the advantages gained through better businesses. In short, equity investors should consider a focus on quality.
Finally, a lead-in to a related topic: If quality pays, what does an investor have to pay for it? Can you find quality in today’s market at value prices? The answer is yes, and it will be the topic of an upcoming publication.
The relationships between fundamentals, volatility and expected returns have a number of consequences for investors. First, quality can be defined for equities with fundamental analysis. Second, the factors that define quality tend to lead to lower risk in individual equities. Third, as these fundamental factors in part lead to lower volatility, they may also lead to higher returns to the extent the stocks participate in the low volatility anomaly. Strategies that focus on these fundamental factors may generate more alpha due to the advantages gained through better businesses. In short, equity investors should consider a focus on quality.
Finally, a lead-in to a related topic: If quality pays, what does an investor have to pay for it? Can you find quality in today’s market at value prices? The answer is yes, and it will be the topic of an upcoming publication.
(c) PIMCO
