Quality: The Real McCoy

At GMO we have spent the last four decades taking a long-horizon approach to equity investing. Over time, a unique and reliable group of standout companies emerged from our research. Through market cycles and dislocations, high-quality equities have proven to be a stable group of exceptional businesses ideally suited to compounding capital. While equity styles go in and out of favor, quality companies continue to serve clients as a core holding, resilient to economic headwinds and market drawdowns. For long-term investors searching for a durable equity solution, we believe quality is “the real McCoy.”1

History of quality investing at GMO

GMO has managed a quality equity strategy since 2004, yet the history of quality research and investing at GMO can be traced back even further, to the earliest days of the firm. When Jeremy Grantham and his partners founded GMO in the late 1970s, Jeremy was grappling with the conundrum that high-quality business models are difficult for value investors to own because they tend to trade at premiums to the market. He recognized that a framework that enabled an investor to determine the relative quality of business models would give a truer sense of the intrinsic value of companies. Jeremy’s research led him to three key identifiers in a company’s financial history that are sound indicators of quality business models. Companies with a record of high profitability, stable profitability, and low leverage are most apt to be able to continue to grow at high rates of return throughout the business cycle and in various economic environments. By incorporating these quality factor terms in GMO’s early quantitative value models in the 1980s, GMO was able to own great businesses trading cheap relative to their quality-adjusted intrinsic value and also developed a better sense for when classic value companies were cheap for a reason and thus should be avoided.

As GMO built out its asset allocation capabilities in the 1990s, it became clear that the quality group of companies was a distinct third factor, or style, alongside value and growth and could be equally predictive of future return expectations. During the period marked by the expansion and bursting of the dot-com bubble, quality stocks moved independently of growth and value stocks. By the early 2000s, large cap growth stocks remained expensive, and value stocks had caught up. That left one group of companies with an attractive return forecast: quality.