Review Spotlight: You Can Never Go Wrong With Quality

For some time, we have been arguing that higher-quality companies would lead in the market recovery regardless of market capitalization and especially as the economic recovery matures. This is related to our core belief that finding high-quality companies is paramount to our efforts to mitigate risk and achieve above-average, long-term returns.

It has always seemed to us that companies with strong fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices, but has that in fact been the case? More than two years into the rally, many high-quality stocks still look attractively undervalued. This is not surprising, as quality stocks are defensive by nature and tend to perform better as the economy migrates from recovery to expansion, which is precisely the kind of environment that we believe the market is entering.

Of course, definitions of quality vary so widely that the word currently risks being the most overused term in the investment community. After all, who would admit that their portfolio isn't high quality? Still, our own understanding of quality is critical to our investment efforts. For us, quality is best seen in a company's balance sheet and in the returns, or consistency of returns, that the business generates.

To best understand the second of these two measures of quality, we evaluate a company's historical returns, with a particular focus on return on invested capital (ROIC). This measure helps us to quantify a business's record of success, i.e., returns generated on the capital that it has employed. ROIC is defined as EBIT (earnings before interest and taxes) divided by total capital (shareholder's equity plus debt minus cash). While we believe that high-quality companies are currently well positioned in terms of return potential, it's important to examine how companies with above-average ROIC have fared over meaningful time periods such as full market cycles.

For some insight into this question, we sorted the non-financial constituents of the Russell 2000¹ into ROIC quartiles using FactSet derived trailing 12-month results. Quartile 1 represents those companies with the highest ROIC and Quartile 4 those with the lowest. In addition to re-sorting constituent companies quarterly by quartile, our results also reflect two Russell rebalancing practices, namely the annual reconstitution in June and the quarterly addition of any new index entrants via IPOs. We went back as far as we had reliable data, to the mid-1990s, and then sorted the data by market cycle performance including peak-to-trough, trough-to-peak, and peak-to-peak periods. The method allowed us to assess results over three full market cycle periods plus the peak-to-current period as well. Finally, since we were unable to track results from specific Russell 2000 peaks and troughs, we elected to use month-end performance data nearest each peak and trough.

While we recognize that quality may move in and out of favor during shorter time periods, we sought an answer as to whether quality has a long-term pay-off. Data going back to the May 1996 small-cap peak through 3/31/11 suggests that quality (Quartile 1) has provided superior results relative to low quality (Quartile 4) and the Russell 2000 index as well.

Peak-To-Trough Results

Our initial thesis heading into this study hypothesized that quality would generally outperform during downdrafts, lag in up markets and outperform over full cycles.

This initial thesis proved to be correct: In the previous four downdrafts, while quality still went down, it more than held its own. In fact, in the last three peak-to-trough periods, Quartile 1 outperformed each of the other three quartiles. It was only during the shortest downturn (5/31/96 - 7/31/96) that Quartile 1 failed to lead. More impressive, Quartile 1 companies on average, as measured across all peak-to-trough periods, outperformed all other quartiles and the Russell 2000 Index as a whole.

Trough-To-Peak Results

Although not perfectly correlated, lower quality generally outperformed higher quality during major market up swings. Quartile 1 companies were both the worst performing and the second best performing during the trough-to-peak period measured. On average, the highest-quality companies were the worst performing quartile yet were still ahead of the Russell 2000 Index returns (due to the exclusion of financial companies).

Peak-To-Peak Results

Full market cycle results saw Quartile 1 companies finish first, second and third over three full market cycles; they currently reside in third place for the 6/30/07-3/31/11 period. Interestingly, in three out of the four full market cycle periods measured, Quartile 1 outperformed the Russell 2000 Index; on average, it outperformed both the small-cap index and the other three quartiles.

Quality Never Goes Out Of Style

We fully recognize that security selections based on a single factor are not advisable. Nevertheless, quality is a key attribute, especially within the small-cap universe where businesses are more fragile and volatility is inherently higher.

While we would agree with those who suggest that now is the time for quality, it has actually been an integral part of our investment criteria for the past several decades. Over the next 10 years, alternating market leadership will likely be the norm. Yet when this decade comes to a close, we believe that our focus on quality will have been a major contributor to achieving our desired results.