In a recent conversation with the fund manager Mark Slater, we discussed what it means to invest in ‘quality’ companies (the full interview is pending). In many ways it’s a simple strategy to understand. A high quality business, he argued, can compound your money many times over long periods. They’re comforting to own, they’re well run and their results are predictable - you hardly ever have to worry about them. But while all those reasons make a lot of sense, there is still some debate about why high quality firms tend to outperform.
On one hand, it makes intuitive sense that great stocks should beat junk stocks. But according to new research there’s an interesting behavioural bias at work here as well. It turns out that investors and analysts actually don’t pay enough attention to (and may even completely ignore) some of the profitability signals that are the hallmark of quality stocks. As a result, they form an inaccurate view about them and are left playing catch-up as new information about those stocks emerges.
Figuring out market anomalies
Before digging into the nature of quality, it’s worth having a look at some context, and how it fits together with other market ‘anomalies’. In the 1960s a number of market researchers lined up behind what was known as the ‘efficient market hypothesis’ (and many still do). It’s a theory that generally claims that every single piece of information known about a stock is reflected in its price. So the idea goes, it’s very hard for investors to beat the market.
A fly-in-the-ointment is that there are anomalies that sit awkwardly with the idea of market efficiency. Easily the biggest is value investing. The predictive nature of buying shares when they’re undervalued by the market dates back to Ben Graham in the 1920s and beyond. Since then a stack of research has concluded that stocks priced cheaply against what they earn or what they own tend to outperform stocks that are expensive.
Evidence suggests two main reasons for this. One is that investors demand a risk premium (a higher return) for buying cheap stocks that may never recover. The second is behavioural - investors extrapolate past trends in the expectation they’ll continue and end up overpaying for glamorous growth and underpaying for unpalatable value.
Another anomaly is momentum. This is the tendency for prices that have recently seen strong positive or negative…
