Inverse Performance Between Quality & Value

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In their recent episode of the VALUE: After Hours Podcast, Jake Taylor, Bill Brewster, and Tobias Carlisle discussed the Inverse Performance Between Quality & Value. Here’s an excerpt from the episode:

Tobias: Verdad, this was written by Greg Obenshain. I’ve heard Dan Rasmussen on the podcast. The article was how does quality work? I thought it was a fun article because their definition of quality, they’re using a variety of factors but they’re using the Novy-Marx gross profits on total assets as their main one. Then their value metric is gross profits on enterprise value. So, it’s like a book value version– or sorry, like a PE version of value. So, they’re comparing the two.

What they have found is that value slightly outperformed quality over the full dataset that they have. The margins, not much. The most interesting thing I thought was that there seem to be– if you take the long-short version, so the market neutral version, and you take quintile, the most expensive quintile minus the cheapest quintile, or you take the best quality minus the worst quality, quality minus junk, which is the way that AQR characterized it in their paper which came out in 2013 I think something like that, basically, you find that it has this interesting performance where when value does really badly quality seems to do quite well, and then when value does quite well, quality seems to not do as well.

So, they’ve got the chart in it, I think that is the most interesting one. It is just the long-short comparing. It’s only a couple of decades, it’s 1996 to 2021. Not really sure what quality looks like outside of that. I know that it has outperformed, but I just don’t know if it has exhibited this particular behavior where there have been two kind of big selloffs for value over that period of time, 1996 to date. Late 1990s, of course, and then more recently. They’ve characterized the most recent one as finishing in 2020, 2018 to 2020. So, I was very relieved to learn that so far. [chuckles]

Jake: [laughs]

Tobias: They’re bolder than I am, but I’ll take it out of mind. Confirmation bias is how I keep going. Quality stole that from about 2013 to 2020, and this is something that I’ve observed a few times. I’ve been running my own little tests on this stuff, that really quality was very, very flat. Then around 2018, quality just took off, and I don’t really know why.

Then, that’s exactly the same period that value really started selling off. It may be that the just that definition of quality, the gross profits on total assets, has captured that particular technology industry sector, or that part of the market that took off, and so it’s a complete fluke, but I don’t think so. I think that this is a version of the paper that James Montier wrote that came out a long time ago when he was examining the little book that beats the market strategy. He said in that, that there were these times where value basically works outperforms over the long run, but you have these painful periods like the late 1990s where potentially you get fired as a value manager, because he just can’t keep up.

So, I just think it’s a very interesting paper. But the most interesting or another interesting part was the drivers of returns to quality in value. Quality, the drivers of returns seem to be asset growth, which is probably what you’d expect. That’s why you’re buying a quality company because it’s able to generate reasonably good asset growth, and then the drivers of value returns are rerating, so multiple expansion.

Jake: Really, reversion.

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