RMBlack runs a simulated portfolio. The portfolio was established to provide a transparent way for new and existing clients to understand the investment results that can be produced as a result of following our investment recommendations.
This is important for several reasons:
- We hold ourselves as being investment experts. Therefore, it is important that we provide objective evidence that hopefully supports this claim;
- We charge fees for our services. It is important that current and potential clients can reflect upon the investment returns of the model portfolio to determine whether these fees are broadly justifiable (note that there are many more factors that go into justifying a fee charged by an adviser – but investment results form an important element of this justification);
- The portfolio represents the best investment ideas that we can generate. As such, it provides a clear window for current or potential clients to view the sort of investments we typically recommend. It also requires us to outline and discuss our investment philosophy and why we believe that philosophy provides the right environment within which to optimise investment results;
- The investment results of the portfolio provide a validated set of investment results for investments that we presently find compelling.
Focusing on ‘Quality Investments’ has been an essential element that has help drive the investment success of the model portfolio.
When building portfolios, we recommend targeting a diversified selection of investments focused on high quality businesses to provide the best probability of investment success.
Through a wide range of financial literature, the ‘Quality’ factor has been shown to provide outperformance over time with a lower level of volatility. When defining Quality, we utilize both Quantitative and Qualitative analysis of businesses.
For example, a high-quality business will likely have the following characteristics that can be judged qualitatively:
- Growing business operating in a growing market or sector
- Good competitive advantage or pricing power to maintain strong profitability and withstand competition (in investment market parlance, this is referred to as ‘moat’)
- Scalability to become more profitable with increasing revenue. There is limited value in a business getting ‘bigger’ if the profitability declines as a result.
- Quality businesses should not appear mature, or saturated within their sector.
- Business operations should re relatively stable and consistent over time rather than highly volatile or cyclical
- Management should be stable and preferably have strong alignment with shareholders through company ownership
Quantitative analysis of the following characteristics can then provide further weight to the quality factor through the following financial metrics:
- Return on Equity (ROE) should be trending higher. This shows any equity used by the business is generating expanding profits and that earnings delivery is relatively consistent over time. An improving trend in ROE is often more important than a high ROE
- Earnings margins (EBIT Margin or EBITDA Margin) should be expanding showing good scalability. Declining margins typically indicate that either the business is not controlling costs or they are discounting their goods or services to maintain market share.
- Cashflow generation is strong and expanding (often referred to as free cash flow generation)
- Strong balance sheet shown through low Debt to Equity or strong Net Interest Coverage.
Over time, businesses that best meet these characteristics are likely to provide strong performance. However, no single investment characteristic will work all the time, through all market conditions. As such, a strong portfolio should still be flexible enough to adjust to different market conditions that may warrant targeting different investment factors (other than quality).
The chart shown in Figure 1 shows the historical relative performance of the MSCI World Quality Index against the MSCI World Index. As can be seen, the MSCI World Quality Index has strongly outperformed the MSCI World Index over the period shown.
Figure 1.
Conclusion
Many market participants make judgements about which investments to purchase based on those investments being ‘cheap’ or having a high dividend yield (we will write more about these factors in another white paper). Focusing on those investments which demonstrate ‘Quality’ attributes provides an alternative view through which to make investment decisions that has a strong history of producing outperformance.