Everyone’s into buying ‘quality’ – but just what does that really mean?

Quality' investing means buying the firms that pull in the cash, says David C Stevenson.

This week I want to talk about quality'. If ever a word in the investment world deserved to be treated with scepticism, it's this one. Everyone says they're into quality', almost regardless of what they own.

But in an investment context, quality' has quite a precise meaning. But before I get into explaining quality, I need to bring up a concept I've already written about here style biases, also known as factors'.

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Put simply, investors in shares have a choice. You can buy the market (using a FTSE 100 tracker, say), or you can focus on specific stocks that share common characteristics. They could all be cheap value stocks. They could be wildly popular momentum stocks. Or they could be low-volatility' stocks those whose price doesn't move about much.

These three factors' value, momentum, and low volatility are very popular among professional fund managers, with many focusing on one or the other. Quality' has now emerged as a fourth factor, and as a result is hugely popular.

But what exactly does it mean? To answer this, we have to take a look at a paper from some analysts at Standard & Poor's (S&P), who have pinned down just what it is that makes a stock quality'.

Quality: A Distinct Equity Factor? by Daniel Ung and Priscilla Luk and Xiaowei Kang was published in July, and it's worth downloading from S&P's website it's an excellent primer on equity investing.

It also accepts that opinion varies on what makes a quality stock but as far as the authors are concerned, "quality comes in different guises and should encompass compatible, though unconnected, features like cash-flow generation ability, earnings growth and stability, and management efficiency". If that all sounds a bit nebulous, that's because it is but it does seem to work.

S&P sums it up like this. Broadly speaking, high-quality firms aim to generate higher sales and cash, and enjoy more stable growth, than the average company. They "seek to adopt a conservative, yet effective, capital structure that allows them to grow". Finally, they are usually "run by managers who tend to exercise prudence in the administration of the companies' affairs".

These traits help to protect them "from the vagaries of the economic cycle, making them slightly more immune to downturns" when they arrive. But how do you identify them? Three ways stand out:

Return on equity (RoE): this measure compares profitability against the total equity capital used in a business. According to S&P, RoE is useful for identifying good stocks. If a firm has a decent RoE if it's highly profitable it usually indicates some sort of competitive advantage.

Firms like that are more likely to be able to sustain this advantage, "creating an oligopoly within their sector. These advantages can take many forms, from superior branding to intellectual property value." In short, if a company has been unusually profitable in the past, it's likely to remain so in the future.

Balance-sheet accruals ratio: this sounds dull, but is easy to understand. "The more a company's accounts are made up of non-cash items, the more error-prone their financial statements." Profits should be turning into cash. If they're not, you have to wonder why not.

Financial leverage: this is all about how much debt is in a business. This can tell you a lot about a company's financial health and "whether its financing arrangement is sustainable", or whether its levels of debt could end up holding it back, or even lead it into trouble.

S&P found that choosing the best firms based on these three measures to build a series of quality' indices made a significant difference to returns. In back-testing, "the S&P quality indices beat their respective market-cap-weighted benchmarks across the board between 2000 and 2013" by quite a margin.

"The S&P Global, Developed and Emerging Quality indices achieved annualised returns of 7.5%, 7.5% and 10.5% respectively, surpassing their benchmarks by 3.6%, 3.7% and 2.9% respectively." The bottom line is that quality stocks outperform.

They manage this fairly consistently over time, across a range of countries (the most in America, with 5.4% outperformance, and the least in Japan, at 0.6%) and also during different market phases (they tend to lag slightly in bull markets, but provide some downside protection in bear markets).

If we apply a quality screen' to stocks, what sorts of companies do we get?Those that crop up are health-care businesses, consumer-staples giants (which tend to be based around brands), energy stocks, and IT companies.

The utilities and telecoms sectors tend to be under-represented. So what does this all mean in terms of choosing funds and fund managers to invest in?

In the exchange-traded fund (ETF) sector, US group PowerShares offers an ETF that tracks an S&P quality index (the PowerShares S&P 500 High Quality Portfolio NYSE: SPHQ).

But I suspect the easiest way for UK investors to access this theme is to use the Lyxor ETF SG Global Quality Income (LSE: SGQD). It uses a methodology called the SG QI, which stands for Societe Generale Quality Income index (SG owns Lyxor).

This builds on quality' investing, but adds an income dimension. In the year to date, the ETF has returned 14.56% to the end of last month, versus 11.7% for MSCI World, and 12.6% for MSCI World High Dividend Yield index.

On the active funds side, I'd say the best option is the Finsbury Growth and Income Trust (LSE: FGT), run by Lindsell Train and managed by Nick Train. Train is probably the best quality fund manager in the UK.

He embraces the soft', qualitative side of this style the aspects of a company that can't necessarily be captured by fundamental measures. In particular, he focuses on great brands (echoing Warren Buffett).

What's fascinating is to look at Train's top ten holdings and compare them with his peers in the UK and global equities sector. His peers tend to hold the likes of Royal Dutch Shell, Vodafone, HSBC, BAT, GSK, and BP in their top tens.

Train, on the other hand, has the following key holdings: Unilever (9.7%), Diageo (8.8%), Reed Elsevier (7.2%), Pearson (7.2%), and Heineken (6.7%) all brands with strong intellectual property.

This is mimicked in Train's other vehicle, the Lindsell Train investment trust (LSE: LTI) where top holdings include AG Barr, Diageo and Unilever, plus a chunky equity holding in the underlying fund manager.

Only a few other managers can possibly hope to compete in this area Scottish Mortgage (LSE: SMT) has a distinctive mix, but is more focused on racier growth stocks, while Monks (LSE: MNKS), Personal Assets (LSE: PNL) and Witan (LSE: WTAN) all have not dissimilar holdings.

For me, Finsbury's relentless focus on quality businesses, and its performance numbers, speak for themselves. Over the last ten years, its return on net asset value has outpaced the benchmark by 10% a year on average.A core holding for the long-term investor.