Investing in the quality anomaly

17 August 2021

Tony Breen

Independent Committee member, Findex Investment and Asset Allocation Committee

Human emotions are imprinted into every person and are largely independent of time. Shakespeare’s works speak of love, greed and envy and are as relevant today as they were over 400 years ago when they were composed.

These same behavioural traits are evident when people invest and can be observed in many ways. Whether it’s the extremes of share market bubbles and busts, or in a more subtle manner like the way certain assets are perceived and valued, being aware of these issues enables experienced investors to capitalise on them.

Early research (dating back over 50 years) into how behavioural traits affected asset prices (specifically shares), led to the conclusion that there was no way to achieve above average returns on a sustainable basis. This assumed that investors were rational and that prices immediately reflected all the available information, meaning all shares were fairly priced at all times. The significant growth of index funds, which largely capitalise on this concept, are testimony to its adoption.

Since then, as more data became available and computing power increased, further research introduced the concept that while people may be rational in the long term, there was strong evidence this was not the case in shorter time periods.

A simple but common example is herd mentality, where people believe that if many others are doing something it must be right. This led to a series of investable anomalies being unearthed, each of which have particular characteristics. Knowing how they behave and when to use them is part of the toolset of a professional investor.

The driver of the quality anomaly: confirmation bias

Warren Buffet, one of the world’s most respected investors, was quoted as saying “what the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”

What he was describing is confirmation bias, which is defined as ‘paying more attention to information that reinforces previously held beliefs and ignores evidence to the contrary’. Its strength and breadth are evident in almost every facet of life.

In USA in 2018 alone, there were 151 cases of exoneration representing individuals who had spent a total of 1,639 years behind bars for crimes they did not commit based on eyewitness testimony which was later found to be flawed due to stereotyping. In advertising, executives spend their lives seeking to counter confirmation bias when promoting new products or exploiting it for established brands.

In investing, confirmation bias is evident in the rates at which investors update their forecasts for key metrics of stocks, which can lead to them missing much of the gain (or failing to avoid the loss) in a stock’s value.

Quality stocks have such strong metrics relative to others on a range of variables (like profitability) that investors are slow to believe they will persist, leading to stock prices taking some time to fully reflect existing information.

Due to this bias also being attributed to other financial markets traits, it has been described as probably the most persistent and economically significant of the documented behavioural biases.

What are quality stocks?

Like beauty, quality is in the eye of the beholder. While there is no universally accepted definition, investors generally contend that they exhibit some or all of the following:

  • Consistently high profitability
  • Persistent and predictable earnings growth
  • Low financial leverage
  • Conservative deployment of capital
  • Strong corporate governance

Amongst other things, these characteristics come from durable business models and sustainable competitive advantages, which enable them to perform well in most environments. In particular, it provides them with a margin of safety which enables them to withstand negative business cycles, thereby offering a level of protection from market declines. Examples of such stocks are Microsoft and Visa.

Investing in a portfolio of quality stocks can help provide investors with the opportunity to outperform the market over time, with lower drawdowns in negative market conditions generally followed by faster rates of recovery.

Importantly, as confirmation bias is universal, the quality anomaly can be employed in equity investing all around the world, thereby potentially offering a significant opportunity to benefit from it. As these companies tend to be quite large, it enables significant amounts of money to be employed in this manner.

As you can imagine these characteristics seem like nirvana, so it should come as no surprise that there are not an enormous number of stocks with these attributes, however certainly enough for a diversified portfolio.

Benefits of investing in the quality anomaly

While others change their opinions in a slow and steady manner, investing your money in a way that exploits confirmation bias and other biases may help to give your portfolio the edge. By us favouring quality shares (with an additional attribute of ones with higher growth rates than the overall market) in the portfolios we manage for several years, your investments have benefitted from the overall strong performance these have delivered while having added a level of protection against dips when they occurred However, past performance is not a reliable indicator of future performance and future results are impossible to predict. As an investment strategy used by the Findex Investment and Asset Allocation Committee (FIAAC), investing in the quality anomaly can have many benefits. However, we are mindful that there are conditions in which it will not perform as well as other strategies we could pursue, so we constantly monitor investment conditions to adopt alternatives when and if they are preferred.

For further information, speak to your adviser or get in touch with the Findex Wealth Management team, who can help you develop a financial plan and investment strategy to meet your current and future goals.

Sources:

Efficient Capital Markets: A Review of Theory and Empirical Work: Eugene F. Fama Source: The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 383-417

The Intelligent Investor, 4th edition, 1973: Benjamin Graham

Exonerations in 2018, The National Registry of Exonerations, April 9, 2019, http://bit.ly/ExonsIn2018