A Framework for Superior Risk-Adjusted Returns: High Quality Stocks in Developed Markets
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“The risk of paying too high a price for good quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at times of favorable business conditions.” – Benjamin Graham
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." – Warren E. Buffett
As the above quotes illustrate, quality-driven investing has been around for quite some time. However, it has gained renewed momentum over the past decade driven by the spectacular crashes experienced after the technology boom and during the global financial crisis.
Academic research has also revealed the benefits of quality-driven investing. Over the last few years, several academics have weighed in on the quality factor and many papers have been written trying to identify criteria to define it. Further, quality is becoming widely accepted as an anomaly and is now being designated by many researchers as a fifth factor explaining investment returns along with the four widely accepted factors: beta, size, momentum, and value. This development is in sync with our long-held belief that quality is a distinct investment style.
This article builds on a number of studies that have explored returns to factors such as profitability, the relationship between accounting, and economic profits and leverage. Robert Novy-Marx (2013) showed that stocks with high gross profitability as measured by gross profits to assets outperform. Chan, et al. (2006) showed that the difference between accounting earnings and cash flows are negatively associated with future returns. George and Hwang (2010) showed that stocks with low leverage have high alpha.
We will discuss the investment returns from a simple quantitative process of selecting high-quality businesses. In valuing such businesses, market participants systematically underestimate the duration of competitive advantage. Because of this, the valuation premium assigned does not sufficiently account for the difference between the business value creation potential of a high-quality business as compared to the average business. Indeed, a basket of high-quality stocks generates significantly superior investment returns compared to publicly traded benchmarks, and it does so with significantly lower risk.
Long-term returns1 of U.S. equities
Over the last 130 years, U.S. equities2 have generated a total return of 8.9% annually including dividends3. While there has been significant variation in year-over-year returns, the long-term picture is that of a consistent compounding of wealth as seen in Figure 1.
Components of investment returns
The total investment return from equities can be decomposed in four components: dividends4, inflation, real growth in business value, and change in Mr. Market’s5 “perception” of the value of those businesses. Equation 1 below formulates the decomposition of total investment returns among those four components.
Total Return from Equities6 = Dividend Yield + Inflation + Real Gr in Business Value + ∆ Valuation ascribed to Businesses
While dividend yield and inflation are straightforward numbers, we need some proxies for growth in business value and changes in valuations ascribed by market participants to businesses. For the purpose of our analysis, we have used growth in cyclically adjusted earnings7 as the proxy for business value growth and changes in cyclically adjusted price-to-earnings ratio (CAPE) as the proxy for changes in valuation ascribed to businesses by market participants. Table 1 shows the contribution to total returns from U.S. equities from these four factors over the last 130 years. Clearly, dividends have been the largest component of the total investment returns.
Table 1 – Components of U.S. equity returns
Modified equation for approximating total returns
While changes in business valuations are an important driver of returns over short and intermediate terms, their impact on total investment return over very long periods should be insignificant. This is because interest rates and growth expectations--the two primary drivers of the multiples assigned by market participants to cash flows or assets of businesses--revert to the mean in the long term.
We contend that changes in business valuations over very long periods of time should be a tiny component of total returns. Table 1, supporting this, shows that changes in valuation ascribed to businesses, using changes in CAPE multiple as a proxy, were a very small contributor to total investment returns at 0.3%.
With this insight in mind, the equation to approximate total return from equities can be rewritten as follows:
Long-Term Total Return from Equities ≈ Dividend Yield + Inflation + Real Gr in Business Value
Further, inflation plus real growth in business value approximates the nominal growth in the business value and so the equation above can be further modified as below:
Long-Term Total Return from Equities ≈ Dividend Yield + Nominal Gr (Business Value)
- In an editorial in the Financial Analyst Journal in 2003, “Dividends and Three Dwarfs,” Robert Arnott showed that US equities compounded investor’s assets at 7.9% over 200 years from 1802 to 2002. This investment return consisted of a 5.0% return from dividends, a 1.4% return from inflation, a 0.8% return from real growth in dividends, and a 0.6% return from rising valuations.
- For the purposes of this paper, U.S. equities refer to S&P 500 and its components.
- Using data provided on Robert Shiller’s website http://www.econ.yale.edu/~shiller/data.htm
- In “The Triumph of Optimists: 101 Years of Global Investment Returns”, Elroy Dimson Et al. showed that dividends account for a significant part of the total investment returns over long periods. From 1900 to 2000, a US portfolio that included reinvested dividends would have generated 86 times the wealth generated by the portfolio solely relying on capital gains.
- Mr. Market is an allegory created by Benjamin Graham. While explaining the fluctuations in stock prices, Graham says, “Think of you as owning a share in a business in partnership with others. One of your partners, say Mr. Market, is somewhat of a neurotic who on any given day will offer to buy your share or sell you his at a specific price. His moods can fluctuate anywhere between incredible optimism and overwhelming depression. One day he will nominate a higher price to buy or sell, the next day he might increase it, lower it, or even appear uninterested in whether he buys or sells.”
- There is also a residual component, which is largely a factor of the geometric interactions of the various factors when they are compounded over the long-term. However, for the purposes of our analysis this has been ignored as it tends to be a very small component compared to the other four components.
- Cyclically adjusted earnings (CAE) refer to the smoothed earnings measure popularized by Robert Shiller. It is calculated by taking a 10-year average of inflation adjusted trailing earnings. Cyclically adjusted PE (CAPE) is calculated by taking the inflation-adjusted prices of S&P 500 and dividing it by CAE.