Rudi’s View: Quality Reigns, And How To Identify It

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In this week's Weekly Insights:

-Quality Reigns, And How To Identify It
-Macquarie's ASX Quality Compounders

By Rudi Filapek-Vandyck, Editor

Quality Reigns, And How To Identify It

I used to think investors' biggest challenge was related to a cheaper share price not always presenting a better opportunity, or that built-in urge we all have to be part of the next share market rally -FOMO! by any other name- but as my experiences grow, and my daily observations accumulate, I am now of the view the biggest challenge is coping with change.

Given we are experiencing a once-in-a-lifetime period of innovative disruptions and technological breakthroughs, adapting to change may well become the all-important factor that separates the Winners from Losers, both in the real economy as among listed equities, but equally so for those investing in them.

GenAI and GLP-1s are now on everyone's radar given a strong presence among share market winners, but very few are equally aware about the small revolution that has taken place over the past two decades in terms of how to 'value' those companies and their brethren operating in cybersecurity, online retailing, and capital-light software and technology services generally.

Admittedly, in a market dominated by banks and resources companies, and with a large swathe of investors solely focused on franked dividends, there's never been too much urgency to catch up on modern day methodologies to value young-and-upcoming, fresh, modern-day business models. But even the ASX is changing noticeably.

According to my quick analysis, six of the ASX Top20 companies are now consistently trading on above-average PE ratios, while that number grows to eleven if I expand the focus to the ASX50.

The local market's sweet spot, companies ranked between 51 and 100 on market cap, offers plenty of growth achievers on higher multiples that look poised to develop into potential ASX50 members in the decade ahead.

But the likes of Car Group ((CAR)), Pro Medicus ((PME)), WiseTech Global ((WTC)) and Xero ((XRO)) do not only provide investors the opportunity to outperform the local benchmark, their ascendancy is also impacting on traditional measurements to determine whether the local share market as a whole is 'expensive' or not.

Simply put: drawing a straightforward comparison with how the index traded in the past should no longer cut it, if ever that was the case given BHP Group's ((BHP)) heavy weighting today.

Even if we ignore the counter-cyclical PE formation for Australia's largest index weight (high in downturns, low when the sun shines), the elevation of the likes of CSL ((CSL)), Goodman Group ((GMG)), Macquarie Group ((MQG)) et al means the average PE ratio for the Australian share market has by default increased vis a vis the lower references from the past.

So where exactly is today's 'equilibrium' in between undervalued and overheated? Since no such research has been conducted to date (not to my knowledge), we do not know the answer, other than it will be higher than the market's long-term average which is usually placed below 15x times forward earnings per share (EPS) projections.

The current average has already been impacted as the prior corresponding average was long quoted as 14.4x previously. My 'hunch' is today's number might be closer to 16x. Post August weakness, and the recent return of buyers, the average PE ratio for the ASX200 is now a smidgen above 16x.

My 'hunch' might not be too far off, or so it seems. Early conclusion: don't jump to the 'market is overheated' conclusion too quickly; the past does not offer apples with apples comparison (at least not on this widely used market valuation metric).

The same principle also applies to overseas indices, of course.

Value Versus Quality

A much more important change has taken place for investors' ability to identify winners and losers on the market. Still, the large majority thinks of low PEs when looking for opportunities, but there's a growing mountain of evidence suggesting low PEs have no predictive powers when attempting to find tomorrow's winners (beyond that brief rally).

Instead, achieving oversized investment returns over the past decade or so has been closely linked to High PE achievers such as the ones mentioned earlier. So, are we experiencing the next bubble waiting to burst? Is the late Benjamin Graham ringing alarm bells from his grave?

Hardly. Today's scholars will tell us the legendary Graham was much more flexible than his value-seeking disciples tend to be. What usually is ignored when investors base their investment philosophy on the principles explained and documented in The Intelligent Investor is that Graham never simply focused on buying 'cheap' assets – he'd also apply a quality filter.

'Quality', rather than 'Growth' or 'Value', has increasingly captured institutional investors' attention amidst changing market dynamics. There's one easily identifiable reason for this: those portfolios that own a variety of high PE achievers, be they on the ASX or on Wall Street, have significantly outperformed portfolios that stuck with AMP Ltd ((AMP)), Healius ((HLS)), Aurizon Holdings ((AZJ)) and other low PE 'value' opportunities.

Yes, indeed, share market dynamics have changed, posing enormous challenges for those investors not willing or unable to adapt. That sound you're hearing in the background is from Charles Darwin's grave.

The discovery of 'Quality' as a major defining factor has not happened overnight. Most indices and data providers, including MSCI and S&P, have compiled their own indices and stock selections representing 'Quality' and in most cases the outperformance of Quality over broader benchmarks looks pretty straightforward.

As we're talking about stocks trading on above-average PE ratios, times of significant bond yield resets are not favourable, but outside of 2022 and comparable periods, Quality indices typically outperform during tough times, either economically or because of elevated risks, and during times when 'Growth' outperforms 'Value', when 'Momentum' trades dominate, and when bond yields embark on a downtrend.

Most importantly; unlike 'Value' and 'Growth' which each tend to have specific periods of (out)performance, Quality works under most circumstances, most of the times. It's not difficult to see the attraction for investment portfolios that like to stay with the winners and avoid as much as possible the losers, without having to churn excessively.

The problem is, however, there is no universal concept or definition of what defines a Quality company, as also illustrated by the observation that all Quality indices and selections available are based on different filters and methodologies.

In a general sense, most filters to find and identify Quality companies revolve around businesses with a leading market positioning, preferably protected by a big moat, generating lots of cash flow, making regular investments, have no leveraged balance sheets, and are highly profitable and consistent in their growth.

Financial metrics used to solidify those characteristics include return on equity (ROE), return on invested capital (ROIC), high margins that remain relatively stable, size of investments made, and measured volatility in revenues, profits and those metrics used. Fundamental analysts will also include industry structure and outlook to determine true competition and threats.

As consistency and predictability play a central role, companies that comply with all filters applied are usually not from ultra-cyclical sectors such as resources (mining & energy) or discretionary retailing, and neither are sectors such as financials, utilities, telecommunication, or real estate (REITs) popular hunting grounds.

Sectors that tend to generate most Quality contenders are healthcare, technology, and consumer staples, as is also apparent from my own research into All-Weather Performers (see further below).

Macquarie's Quality Compounders

The team of quant analysts at Macquarie recently conducted another in-depth exercise in an attempt to provide additional insights into the merits of and the methods used to identify what they labelled as Quality Compounders; businesses that have distinctive competitive advantages, supported by robust cash flows, a steadfast balance sheet, a high and dependable return on capital, and promising growth prospects.

Their at face value observations match those of myself and other analysts that have conducted similar analyses in the past; Quality equals long-term outperformance, even with valuations standard at a (sizeable) premium to the rest of the market.

As a matter of fact, one of the highlighted observations from the Macquarie research report is there's no observable connection between cheap/high valuations and investment returns from Quality performers. The suggestion made is this is because Quality tends to outperform expectations, in a general sense, and share prices tend to underestimate future growth potential, even if they seem highly priced in the here and now.

One of the most important characteristics when it comes to finding Quality Compounders, according to the Macquarie research, is persistently high profitability. The analysts identified this as the most powerful distinguisher of truly Quality performers and apply this aspect by measuring whether a company was in the top 33% of stocks by profitability at least four times in the past five years.

Removing companies with a low growth forecast also substantially improved the value of the analysis conducted.

In the end, the search for a better identification method for Quality Compounders has significantly exceeded Macquarie analysts' expectations, with stock selections ending up smaller, but higher-performing in backtesting modeling.

From the MSCI World Universe, Macquarie's additional filtering generated a list of 93 Quality Compounders, including household names such as Alphabet, American Express, ASML, Eli Lilly, Ferrari, LVMH, Microsoft, Nike, and Procter & Gamble.

Lesser-known names included are Automatic Data Processing (ADP), Cadence Design Systems, Sherwin-Williams, FactSet Research, Paychex, Service Now, and Wolters Kluwer.

In Australia, the ASX300 has generated a short-list of 15 companies selected, plus a further 11 that narrowly missed the boat (like CSL, for example, because of post-covid interruption). Those two lists are displayed further below.

All in all, Macquarie's research has a large overlap with my own post-GFC analysis into All-Weather Performers, but it equally comes with more details to digest and to possibly take on board, plus a number of fresh names that have not been on my personal radar up until now.

Most importantly, I'd argue, the research has delivered yet more empirical evidence that Quality matters, it possibly matters more than 'Value' or a cheap share price. It's up to you, self-researching and self-managing investors, to draw conclusions, and take this on board.

Unless, of course, one is inclined to think the decade ahead will be fundamentally different from the decade past, which certainly is not my base case forecast (au contraire).

More reading:

–https://fnarena.com/index.php/2024/04/24/rudis-view-a-market-narrative-delayed/

–https://fnarena.com/index.php/2024/04/17/rudis-view-shaky-sentiment-ahead-of-corporate-updates/

–https://fnarena.com/index.php/2024/04/10/rudis-view-lessons-observations-from-asx-all-weathers/

–https://fnarena.com/index.php/2024/04/04/rudis-view-in-search-of-the-holy-grail/

–https://fnarena.com/index.php/2024/04/03/rudis-view-investor-worries-gold-westpac-and-conviction-buys/

–https://fnarena.com/index.php/2024/03/27/rudis-view-facts-fiction-about-gold/

Macquarie's ASX Quality Compounders

The highest quality 'compounders' as identified by Macquarie quant research inside the ASX300:

-James Hardie ((JHX))
-Cochlear ((COH))
-REA Group ((REA))
-TechnologyOne ((TNE))
-ResMed ((RMD))
-Data#3 ((DTL))
-Pro Medicus ((PME))
-Jumbo Interactive ((JIN))
-PWR Holdings ((PWH))
-Netwealth Group ((NWL))
-Aristocrat Leisure ((ALL))
-Spark New Zealand ((SPK))
-Codan ((CDA))
-Clinuvel Pharmacauticals ((CUV))
-Redox ((RDX))

Given Macquarie's research strong leaning on the past five years, with high barriers to match, the following 11 companies fell just outside the above list:

-Fisher & Paykel Healthcare ((FPH))
-Medibank Private ((MPL))
-Coles Group ((COL))
-The Lottery Corp ((TLC))
-Lovisa Holdings ((LOV))
-CSL 
-IDP Education ((IEL))
-Pinnacle Investment Management ((PIN))
-ARB Corp ((ARB))
-Breville Group ((BRG))
-Johns Lyng ((JLG))

My research and All-Weather stock selections are 24/7 available for paying subscribers: https://fnarena.com/index.php/analysis-data/all-weather-stocks/

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(This story was written on Monday, 29th April, 2024. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).

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