I once waded through “Atlas Shrugged,” Ayn Rand’s interminable tome about libertarianism. It’s five times the length it should be, and I was left wishing that the story — which was, at heart, a brutal satire — had been written by someone like Evelyn Waugh instead. But there were some entertaining gems. This exchange leapt out at me at the time and has stuck in my mind since.
“Where did you get the money for your first payment on that property?”
“By playing the New York stock market.”
“What? Who taught you to do that?”
“It is not difficult to judge which industrial ventures will succeed and which won’t.”
One of the fascinating paradoxes of finance is that successful long-term investing isn’t harder than it looks. Actually, it’s simpler than it looks, and knowing too much can be as much of a hindrance as knowing too little. Few things will get you into more trouble on Wall Street than overthinking.
Everyone who wants to retire in comfort needs to deal with Wall Street, if only when it comes to investing the money in their 401(k) plans and individual retirement accounts. So it’s something that affects us all.
If you want to see how simpler can often be better, look no further than the case for so-called quality stocks.
Boring, better-managed, higher-quality companies with more stable earnings, better market positions and stronger balance sheets have been better investments over time than more speculative alternatives. What is more remarkable still is that they have produced higher long-term returns and lower volatility.
Ben Inker, the co-head of asset allocation at white-shoe Boston fund firm GMO, has just made this point again, forcefully — to coincide with the launch of his company’s first ever exchange-traded fund, which picks quality U.S. stocks.
“Within both stocks and high-yield bonds, you have historically been able to achieve both higher returns and lower risk by owning the highest-quality securities in those universes,” he wrote in his latest quarterly letter. Going back to the 1990s, he noted, “the highest-quality quartile of the market has outperformed the lowest-quality quartile by 4% per year.” This fact is “utterly counterintuitive, astonishing, and demands to be incorporated when building sensible equity portfolios. … If you were going to have one permanent bias in your equity and high-yield bond portfolios, it should be in favor of high quality.”
Yes, quality may be subjective. But there are mathematical tools that can separate higher-quality companies from lower-quality ones, and they have generally worked very well. They focus on companies that typically earn higher returns on invested capital, that have lower debt and whose earnings grow more steadily instead of bouncing around wildly from quarter to quarter and year to year.
Critics may argue that Inker is simply talking up his own book. GMO, which has traditionally focused on institutional investors and high-net-worth individuals, last month launched its U.S. Quality ETF
QLTY
as its first ever ETF. But GMO has been making the same point about quality, over and over again, for years. I remember GMO founder Jeremy Grantham pounding the table about high-quality stocks as far back as 2007, even when he was predicting everything else was about to implode. He was right on both counts.
And quality, as an investment strategy, has a solid pedigree. It was a key principle behind Philip Fisher’s classic investment book, “Common Stocks And Uncommon Profits.” Fisher essentially argued that the way to make money was to focus on really great companies — great management, great businesses — and then hold them forever. Among those he influenced were the late Charlie Munger, vice chair of Berkshire Hathaway, and his partner Warren Buffett. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” Buffett has famously said.
A decade ago, analysts at AQR, the Greenwich, Conn., hedge-fund company well known for its number-crunching, worked out that Buffett’s extraordinary long-term returns were less of a mystery than outsiders supposed. He had mostly spent his career buying high-quality stocks, boosting returns thanks to the access to cheap money he got from his insurance operations. Quality plus leverage.
The proof is in the eating. MSCI, the financial-data company, has been tracking price indexes of quality stocks in the U.S. and internationally since the mid-1970s, and of total-return indexes — including dividends — since the mid-1990s. In both cases, quality stocks have beaten the standard indexes by a wide margin.
As our chart shows, quality has been an even better way to invest in international stocks, such as in Europe, Japan and Australia, than in the U.S. While U.S. quality stocks have beaten the overall U.S. market by 70% in total since 1994, EAFE Quality — referring to Europe, Australasia and Far East — has beaten the overall EAFE index during the same period by a staggering 180%.
As a technical aside, we note that our chart shows relative performance of MSCI U.S. Quality and MSCI EAFE Quality against their respective benchmarks, meaning MSCI U.S. and MSCI EAFE. Since the mid-1990s, U.S. stocks overall have still beaten international stocks.
GMO’s new fund charges 0.5% a year in fees. Is it worth the money? History says it might be. GMO has been running a quality mutual fund GQETX since 2005. Even after deducting fees, also 0.5% a year, it has beaten a low-cost U.S. index fund such as the Vanguard 500 Index VFIAX fund by an average of 0.7 percentage point a year. And GMO’s fund has beaten the low-cost iShares Edge MSCI USA Quality Factor ETF
QUAL
by a wide margin since the latter was launched nearly a decade ago. During that time, the GMO fund has earned 13.2% a year after fees, compared with 11.5% a year for the iShares fund.
That’s a huge difference, adding up to 26% higher profits over 10 years — a 240% return, compared with 190%. (There is, naturally, no guarantee that will continue.)
The new ETF, incidentally, will pursue a similar strategy to that of the mutual fund, but the company says there will be one key difference. The ETF will be U.S. stocks only, while the mutual fund has been able to invest up to 20% of its portfolio in overseas stocks.
The exclusive U.S. focus of the ETF may or may not be a good thing.
Meanwhile, iShares also offers a quality ETF focused on international stocks
IQLT.
Fees are 0.3% a year. If history is any guide, that will prove even more appealing for anyone who already includes international stocks in their 401(k) — which should be everyone.
This story originally appeared on Marketwatch
