Dear fellow investors,

Academics argue that there are three proven factors of investing: Value, quality (Asness’s QMJ[1]) and momentum. For our discipline, we don’t believe we can add alpha in the latter. Momentum is a weird thing, though proven. To emit a yogi-ism, you either have it or you don’t. Value and quality, in comparison, are easier to price in the security analysis of our investment discipline. While investors have looked at the last decade of failure in value, we would conjecture a new question. Just as no one thought that the brightest academic minds could have produced the failure and banking crisis of Long-Term Capital Management, what if another factor fails terribly for an elongated time? To put it simply, what will happen When Quality Fails?

We bring this question up because in so many ways this is the real problem of stock investing in 2022 and the S&P 500’s pain point over the next decade. We have heard things like price-to-earnings (P/E) ratios don’t account for the balance sheet. The balance sheet is a way to test the quality of a company in security analysis. P/E ratios are just one measure of the many yardsticks of value relative to the income statement. However, these factors can run contrary to each other and even be at odds with each other.

Quality has so captivated the minds of investors because it gives them comfort that the mania we just ended was not 1999. Back then there were no earnings, no return on capital and very little cash stacked up on balance sheets. The mania we have today is good balance sheets and good returns on capital with no problems in sight. The only issue is that there are companies before that have found themselves in this same situation as today. It was the Nifty Fifty in 1972. This was the crème de la crème of blue-chip growth businesses in America. Jeremy Siegel argued in his book, Stocks for the Long Run, that investors could have paid the highest prices ever for these securities and still almost beat the market 25 years later because ultimately the quality of the businesses was so good. They produced higher earnings growth and higher returns on capital than the rest of the S&P 500…but still lost.

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