Quality investing: an alternative that has demonstrated its potential over the past 20 years

In the financial markets, a common debate pits the two most famous styles against each other: value and growth, better known as value investing and growth investing. The differences between the two lie in the way of analyzing the companies in which they invest. However, although the growth style seems to have been the champion over the last decade, thanks to the rise of technology companies, there is another, lesser-known style that has also emerged on the podium: quality investing.

Fund manager RBC Global Asset Management provides the following definition: “Quality investment strategies seek to buy financially healthy companies that have solid earnings and stable balance sheets. Quality is about finding businesses that are efficient with capital”. Meanwhile, international asset manager BlackRock adds that these are companies that are “profitable, have low leverage, and demonstrate consistent earnings over time".

That said, it is necessary to define value and growth investing to understand the differences between the three styles:

• Value investing looks for companies that are undervalued in the market relative to their book value. In other words, these are companies that, according to financial analysis, should be capitalizing a certain amount in the market but are not doing so. Thus, it is understood that market efficiency will eventually return the company to its deserved value, and it will stop trading at a discount.
• On the other hand, growth investing focuses on the company's profits growing strongly over the years, without paying much attention to the market's valuation of the business. 
• Meanwhile, quality investing emphasizes the company's solid balance sheet and attractive metrics such as Return on Equity (ROE), debt levels, and profits. In other words, it doesn't place as much importance on the market's valuation of the company or solely on the profit growth.

Finally, MSCI, the U.S. financial company responsible for creating some of the world’s major indexes, defines this investment strategy as one that seeks companies with "high return on ROE, stable earnings growth year after year, and low financial leverage".

Quality investing has been crowned as the most profitable style of the three over the last 20 years, according to the index compilations by MSCI. The company includes 298 companies from 23 countries that meet the aforementioned criteria in a single index. Overall, the annualized return over the last ten years is 13.17%, and since its inception in 1994, it has been 11.88%.

Meanwhile, the MSCI Growth index, which focuses on companies with the highest earnings per share growth, includes more than 675 companies and has achieved an annualized return of 12.13% over 10 years and 10.37% since the index was created.

Finally, the MSCI Value index is the least profitable of all and focuses on the following three criteria: book value relative to price, price relative to 12-month expected earnings, and dividend yield.  Over the past ten years, the annualized return has been 6.9%, and since its inception, 11.33%.

Investing in quality can be done in three ways. The first is the most complex, as it requires the investor to analyze companies based on the aforementioned criteria — ROE, earnings, and leverage — and to select businesses one by one. 

The second way is through active investment funds, where managers apply the quality philosophy to stock selection. Here, a team of experts would analyze businesses based on the mentioned criteria to build a quality portfolio.

Finally, the simplest method is to use passive management by acquiring an ETF or index fund that replicates the performance of the MSCI Quality index. This way, you invest in the set of businesses that make up the specified index.

Another feature that usually differentiates this investment style is that, generally, its companies tend to be leaders in a specific sector in which the high barriers to entry do not allow competitors to stand up to them easily. 

At this point, one should not forget one of the most famous quotes from Warren Buffett, which captures the essence of this style: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”