During times of volatility and uncertainty, quality investing can be a common buzzword among investment managers and the media alike. But what is it exactly? This commentary discusses what quality investing means and how Global Alpha incorporates its quality bias into its portfolios.

Novice investors often confuse defensive characteristics for quality, as the quality factor falls under the defensive category. However, defensive stocks are defined by their non-cyclicality, which means their financial performance isn’t significantly affected by the state of the economy. These stocks, such as household products, utilities, food suppliers and discount retailers, tend to outperform cyclicals during recessions and also on an absolute basis.

In contrast, quality investing is unrelated to market cycles or sectors. Instead, it’s defined by certain fundamental characteristics that distinguish a company from its peers. These include factors that give a business a more durable and sustainable competitive advantage, as well as profit and cash flow stability. Key variables that define the quality factor include:

• Moat: This term, popularized by Warren Buffett, refers to the factors that allow a company to maintain its long-term competitive advantage over its peers (e.g., economies of scale, intangible assets, switching cost, etc.).
• Business model: A durable corporate structure and business strategy can enable a company to remain nimble and competitive, unlike many Japan-based companies with bloated corporate structures operating in multiple unrelated lines of business.
• Corporate governance: This criterion examines management strength and the quality of the rules of governance. Strong governance practices are now widely accepted within the investment community as beneficial (given the rise of ESG investing).
• Balance sheet: A company with a quality bias tends to have a high return on equity, low and sustainable debt, low earnings growth variance and strong cash flow generation.

Quality is a well-documented source of alpha. Eugene Fama and Kenneth French, who won the 2013 Nobel prize in Economics for their three-factor model (size, value, market risk) have updated their model to include two factors related to quality: profitability and asset growth. This is backed up by other research that has also shown how profitability and stability are as useful as size, value and market risk at explaining returns.

So why don’t all managers have a quality bias? Although many studies illustrate that quality tends to outperform over long periods, there will be times when it does poorly relative to other factors. Most notably, quality companies tend to underperform in momentum-based environments wherein investors disregard fundamentals and valuation and stock winners keep on winning. The last decade has seen many momentum-driven cycles, including the COVID-19 rebound in 2020 during which tech stocks were in vogue and names like Zoom, Robinhood and Peloton were trading at multiples that implied they would become the next Apple or Microsoft.

Quality-biased fund managers can encounter several challenges in such environments, including avoiding speculative names and selling their winners too soon. Quality strategies often incorporate GARP (Growth at a Reasonable Price) even though discussions of quality as a factor do not technically address valuation. However, their bottom-up approach and consistent growth of their companies make these investment managers more aware of the cost they are paying for that growth. Quality strategies can offer superior downside protection and steadier returns than peers despite not experiencing the same highs as momentum strategies.

An example of a quality holding in our portfolios is CVS Group (CVSG LN), one of the U.K.’s largest veterinary practice operators and consolidators. The company’s complete service offering includes laboratories, surgeries and crematoria. CVS is known for hiring new graduates and providing them with training and development, creating a consistent pool of veterinarians in a talent-scarce and competitive industry.

The company satisfies most of our quality criteria, including:

• Economies of scales as a moat: The company’s management has a strong track record of growth through disciplined M&A and sustained organic growth. With over 25% market share in the U.K. and a differentiator as a higher-end veterinary care business, CVS has comfortable pricing power, and generates steady and predictable earnings per share (EPS) and cash flow growth.
• Balance sheet and financials: Despite its M&A activity, the company’s net debt is well below 1x earnings before interest, taxes, depreciation and amortization (EBITDA). Management’s ambitious plan to double EBITDA over the next five years is expected to bring that ratio to a manageable 1.2x EBITDA, demonstrating their intent to maintain a nimble and flexible balance sheet.
• Corporate structure and governance: In 2022, the company made governance structure adjustments to align with the UK Corporate Governance Code, despite not being obligated to comply with the code given its AIM listing. CVS’s governance framework is clear and transparent, with board activity and accomplishments provided to investors in the company’s annual reports.

At Global Alpha, we prioritize quality names like CVS in our investment strategy. The company provides downside protection while capturing above-market rates of sustained EPS and cash flow growth, allowing us to continue to build portfolios from the ground up.

It has been an extremely busy period as we navigated the banking environment. The risk of contagion is top of mind as well as the impact on our investments. The difficulty is that for a bank, added outsized risk can come in many shapes and forms. In 1907, the crisis came from overzealous bank owners attempting to corner the copper market. Today, for SVB, it came from duration misalignment of investments and even cryptocurrencies for Signature Bank. Elevated risk taken by banks often occurs when executives allow deposits and loans to grow faster than what their specific team of lenders and investment managers can handle in relation to risk.

Elevated risk can also come from other sources, such as too much government intervention in the case of the Baoshang bank in China in 2019 or severe mismanagement at all levels in the case of Credit Suisse. That’s the bad news. With 25,000 banks globally and 4,844 in the U.S. alone, let’s expect further difficulties to the system. Outflows are at 1.9%.

The good news is this is taken with extreme attention by government and banking associations. In the last two weeks, our team has travelled extensively, especially in Japan and the U.S. We were actually in California when we noticed the SVB debacle on the Friday. During a Monday morning presentation, a non-portfolio company commented that it had a US$80 million deposit with the California bank. All access to deposits was resolved by 11 a.m., certainly a sign of quick response.

Global Alpha holds larger exposure to financial services firms than bank stocks themselves. Its largest exposure is with Rothschild & Co (Roth FP), which provides global financial advisory (mergers and acquisitions and financing advisory). The company also has a wealth division and merchant bank that account for 24% and 16% of sales, respectively. Tracing back to 1760, the company now operates with 4,200 financial specialists across 40 countries. From its strong Europe-based foothold, the company is successfully growing its operations in North America. Rothschild & Co is presently subject to a takeover bid by the founding family’s financial holding.

Another important position for us in financial services is PRA Group (PRAA US). The U.S.-based company is a leading debt collection agency servicing mostly the financial industry, acquiring debt packages from banks and credit card companies. PRA is vertically integrated, from debt acquisition all the way down to call center-based collections, giving it a strong competitive edge. Increasing regulations implemented in the debt collection industry are certainly favouring PRA in the long term. The company has global footprint, with leading operations in North America and Europe.

Our positioning in regulated banks follows our general philosophy of investing in quality assets where we assess balance sheet strength, operational excellence, competitive standing and target markets. We generally tend to be underweight in banks, as most banks have low exposure to higher-growth investment themes and/or are constrained by increasing regulations. Our holdings include: 

Seven Bank Ltd. (8410 JP): The company provides banking services mainly through automated teller machines (ATM) across Japan. Culturally, the Japanese continue to rely on cash as their preferred payment method, mostly for security and identity theft reasons. Although licensed under a bank charter, Seven Bank majorly operates as a technology company through its 26,253 ATM outlets. Services are growing rapidly supplementing cash distribution, and novel and growing additions include credit and investment services. Its balance of deposits stands at ¥578 billion while its loan book conservatively stands at ¥32.7 billion.

With over 250 banks in our index, Global Alpha has low exposure to direct commercial real estate lending, an area that is being scrutinized with the increasing vacancies in commercial downtown centers. Our direct exposures are the following:

Wintrust Financial Corp. (WTFC US): Wintrust is a financial holding company with community bank locations in and around Chicago and northern Illinois, southern Wisconsin and northwest Indiana. Branded as Chicago’s bank, its lending book is highly diversified with a low exposure (6%) to residential real estate, all else mostly being small commercial (sub US$1.5 million) suburban business loans, with downtown office commercial real estate being a small part. An additional Wintrust differentiator is that it owns 15 bank charters, providing FDIC coverage 15 times over for every customer, or up to US$3.75 million in total guaranteed deposit coverage. We believe Wintrust will gain market share as it further commercializes this service.

UMB Financial Corp. (UMBF US): UMB is a U.S.-licensed bank operating nationwide, with main branches throughout Missouri, Illinois, Colorado, Kansas, Oklahoma, Nebraska, Arizona and Texas. Its US$31 billion in deposits is only 20% exposed to the consumer market. Deposits are otherwise commercial (46%) and financial services (17%). The majority (54%) of its US$17 billion loan book is in commercial and industrial lending. UMB maintains a low loan-to-value ratio (currently at 59%). With a 54% loan-to-deposit ratio, UMB also remains at the low end of the 74% peer median.

As you can see, our investment process has led us to financial services companies and banks with differentiated offerings, competitive advantages and defendable barriers to entry. These specialty-focused organizations tend to operate outside of the core banking space where increased risk (from volatile and unpredictable deposits and loans) is taken to achieve return targets. We will continue to monitor the bank environment as well as the health of our bank investments through direct engagement.