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“Ben felt that what I do now makes sense for my situation. It still has its founding in Graham, but it does have more of a qualitative dimension to it because, for one thing, we manage such large sums of money that you can’t go around and find these relatively small value-price discrepancies anymore. Instead, we have to place larger bets, and that involves looking at more criteria, not all of them quantitative. Ben would say that what I do now makes sense, but he would say that it’s much harder for most people to do.” – Warren Buffett[1] responding on apparent divergence from Graham, emphasis ours.
“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.” –Charlie Munger
“Not everything that counts can be counted, and not everything that can be counted counts.” – William Bruce Cameron[2]
Over the last few years, we have had a boom in global financial markets. This boom, much like the others in past, has not been limited to asset prices. We have had a boom in central banker’s reputations, passive investing and ETFs. One could write at length about each one of these booms. However, this article will limit itself to a specific component of yet another boom – in the PhDs and quants in financial markets and the newly discovered “quality” factor.
In a classic case of man with a hammer in search of a nail, the quants and PhDs, equipped with significantly improved computing capability and their formulas, went on to work on financial data. They found a plethora of investment factors. As with everything else Wall Street, they coined a nice-sounding name; evidence-based investing.
During this boom in investment factors, one of the factors that received a lot of attention these past few years was quality. Several academic research papers were and continue to be published touting the benefits of investing in the so-called quality factor.
As a reminder that investors have short-term memories, yet another investment fad is being lapped up by investors.
Wall Street, as it always does, cashed on this new fad. As investors could not get enough of this newly discovered investment factor, a host of ETFs and indices were launched promising the newly found investment nirvana.
The question that investors must ask is whether this makes sense? To answer it, we must first begin with the definition of quality.
Defining quality, the quantitative way
Let’s start with the way many of the quantitatively oriented market participants define quality. Figure 1 shows the quality criteria used by some of the index/fund providers and academic researchers. As is seen, each of these participants defines quality differently.
In many ways, it reminds us of the ancient Indian fable of the blind men and the elephant. Just as each blind man creates his own version of reality from their limited experience and perspective, each one of the participants has their own definition of quality. Not surprisingly though, there is consistency in one aspect. Each one of these participants reported outperformance driven by their quality factors.
Quality
By Baijnath Ramraika, CFA and Prashant Trivedi, CFA, read the full article here.
