What Do We Mean by “Quality”? By: Gabriel PotterMBA, AIFA® 2014.03.03

In our previous blog post, Circular Reasoning in Due Diligence, we noted that active managers often distinguish between high quality stocks and low quality stocks when making investment selections.  By extension, investment consultants often categorize investment managers by those that invest in high quality stocks and those that prefer low quality stocks.  Consultants may then compare the investment manager performance against their own peers and understand if a particular investment manager is performing in line with expectations.  For example, a high quality investment manager is under-performing their index and the combined performance of peers in their category, but they might be performing in line with expectations, especially if other high quality managers are under-performing by commensurate amounts.  Understanding the underlying selection biases and process used by an investment manager will give consultants (and clients) the ability to more accurately compare their relative performance.

Thorny problems occur when investment managers perform outside of expectations, even when attributing underlying selection biases.  For instance, why is a high-quality investment manager outperforming in a low-quality stock market rally?

So, the next question consultants must ask is what specifically investment managers mean when they talk about quality.  A classic, quantifiable definition of quality refers to the underlying credit used by a stock.  If, for example, the debt issued by ABC Corporation is given a high rating from a credit agency like Moody’s, Fitch or Standard and Poor’s, then the stock of ABC corporation, by proxy, may also be fairly presumed to be high quality.  Alternatively, quality is often used to describe the relationship of debt to equity on a corporate balance sheet.  If XYZ corporation has expanded primarily through equity ownership instead of debt issuance (i.e., it has a low debt-to-equity ratio), then it may be a high quality company.  These two perfectly reasonable, quantifiable, and straightforward definitions– credit rating or debt-to-equity ratio – already face problems with imperfect correlation.  Imagine that XYZ corporation has no outstanding debt whatsoever.  Since it has no debt, it is unrated by credit rating agencies, but it also has a perfectly funded assets that exist for the benefit of the equity owners.  Investment managers might view the company as a more or less attractive selection based on their different quality criteria.

In reality, the word “quality” will mean a hundred different things to a hundred separate investment managers.  Quality has no formal definition.  It could refer to quantifiable attributes, like historical profitability.  It could refer to softer attributes, like management credibility.  The same stock could easily be a high-quality pick for one manager and a low-quality pick for another. 

I’ll never forget a conversation I had with a Large Cap Growth investment manager who attributed his exceptional performance to his high-quality approach.  I wanted clarity so I asked, “what does quality mean for you?”  He answered, “I’ll tell you what it is - just look at my performance.”

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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