WhiteCapability MFS Paper Series Focus Month October 2012 2013

Authors

QUALITY AND VALUE

The essence of long-term equity returns
IN BRIEF

Katrina Mead, CFA Institutional Portfolio Manager

Research based on a review of the 1,000 largest US equities by market capitalization (1975 2013) shows: Higher-quality companies created more value than average companies in the marketplace. Valuation was a more significant driver of long-term investment performance than quality.

Jonathan W. Sage, CFA Portfolio Manager

Companies that are both high quality and inexpensively valued were top performers. Quality persistence: Higher-quality companies generally remained so over time, and lower-quality companies were less likely to migrate up.

Mark C. Citro Quantitative Research Associate

Is there value in identifying quality companies those with strong balance sheets, enduring competitive advantages and a history of steady operational performance and lower earnings volatility through economic cycles? Does investing in high-quality companies lead to a sustainable advantage over the long run?
This paper looks at the performance of the largest 1,000 companies in the United States over a 38-year period, examining higher quality companies and inexpensively valued companies, as well as those that fall into both categories. While the general conclusions of this paper hold for a global universe of securities, we have chosen to show the results based on a universe of US large-cap stocks because more data were available on these stocks over a longer time frame as compared to a universe which also included non-US companies. The trends were largely similar when using a non-US universe for a 20-year subset of the time period of the analysis based on the US data.

BUILDING BETTER INSIGHTS

FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY

OCTOBER 2013

QUALITY AND VALUE: THE ESSENCE OF LONG-TERM EQUITY RETURNS

Quality and value delivered steady outperformance

Our analysis showed that owning companies that are both high quality and inexpensively valued delivered the most consistent long-term outperformance for investors. As shown by the top line in Exhibit 1, the greatest relative performance advantage would have occurred at the intersection of high quality and low valuation. Owning stocks of companies that met our high quality and low P/E criteria would have resulted in cumulative excess returns of nearly 432%, or more than 510 basis points per year over the 38-year study period. The low P/E group of stocks shown in the bottom line of Exhibit 1 those that were most inexpensively valued, regardless of quality generated cumulative excess returns of nearly 338% over the 38-year time period, or an annualized outperformance of roughly 450 basis points. This is significantly higher outperformance than would have been achieved using a quality-only metric over the same time period. The highest-quality companies, regardless of valuation, generated only a modest benefit a cumulative outperformance of 2.1%, or an annualized outperformance of 6 basis points. Since our study period began in 1975, coinciding with the Nifty Fifty valuation bubble, we decided to examine data for the time period 1980 2013 to assess the impact that the unwinding of the valuation bubble had on returns for the highest-quality stocks over our initial evaluation period. In fact, the effect was quite significant. In this 33-year period, a strategy focused on owning the highest-quality companies, regardless of valuation, would have resulted in cumulative excess returns of 24%, compared with only 2.1% for the original evaluation period (1975 2013), and 73 basis points p.a. as compared with 6 basis points p.a. for the 38-year period, reinforcing the importance of valuation as an investment consideration. At the same time, because valuation was a significant source of value for strategies not owning the most expensive stocks during the initial five years of our analysis (1975 1980), the returns for the low P/E group and the intersection universe of high quality and low valuation were less favorable using an evaluation period starting in 1980 instead of 1975. For the period from 1980 to 2013, the returns for the low P/E group of stocks were a cumulative 218% and an annualized outperformance of 399 basis

points, while the intersection universe of high quality and low valuation returned a cumulative 240% and 423 basis points per year. While these are both lower than the returns for the period from 1975 to 2013, they are still substantially positive and substantiate the main conclusions of our original analysis, including the observation that the intersection universe provided the best returns. In line with this, we would argue that both quality and valuation are important drivers of long-term stock price performance.
Exhibit 1: Quality and value drive performance
Cumulative excess returns of low P/E and high-quality and low P/E companies vs. the universe (1975 2013)
500% 400% 300% 200% 100% 0%

High quality and low P/E

Low P/E

78

83

88

93

98

03

08

13

Sources: Compustat and MFS

Outperformance staying power: Another hallmark of quality and value stocks

As shown in Exhibit 2 on the following page, the relative outperformance of high-quality/inexpensive companies over rolling 5-year and 10-year periods is impressive. This group outperformed the broader universe over 88% of the time, when examined over 5-year rolling periods, and turned in an even more impressive 96% outperformance rate over 10-year rolling periods. Another important aspect of quality and value stock outperformance is that the magnitude of periods of relative outperformance is much greater than the periods of underperformance. This is likely due in part to the relatively lower risk profile offered by high-quality characteristics such as low financial leverage and consistent, higher returns, as well as lower valuation.

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OCTOBER 2013

QUALITY AND VALUE: THE ESSENCE OF LONG-TERM EQUITY RETURNS

Exhibit 2: Consistency of outperformance

Rolling 5-year performance of high-quality, low P/E stocks vs. universe spread (1975 2013)
200% High quality, low P/E outperforms 150% 100% 50% 0%

It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Warren Buffett,1989

Exhibit 3: High quality is a persistent factor

Percent of highest-quality quintile companies that remained in this group
90% 80%

Q1

Q1 and Q2

-50% High quality, low P/E underperforms -100% 80 83 86 89 92 95 98 01 04 07 10 13

60% 50% 40% 30%
Sources: Compustat and MFS

70%

Does the quality/value screen offer insights about sectors?

We observed that financial services, utilities and communications stocks were less likely to pass the quality and value screens. This may be due to the low leverage requirement of our quality definition, as these sectors tend to have relatively high financial leverage. Also, many utility and communications companies had lower overall returns. Aside from this observation, no other relationships were apparent.

77

81

85

89

93

97

01

05

09

13

Percentage of companies that started in the highest-quality quintile remaining high-quality companies over rolling three-year periods (1975 2013) Sources: Compustat and MFS

Persistence in quality is meaningful

This study also demonstrated that quality characteristics of companies tend to persist over time. We found that companies in either the highest- or lowest-quality quintiles were the most likely to keep those designations over time. Even high-quality companies in cyclical or challenging industries were less likely to see their returns diminish as often or as quickly as market observers commonly think. As shown in Exhibit 3, on average nearly half of the companies that started in the first quintile of quality were still in this quintile three years later. Furthermore, on average two-thirds of companies that started in the first quality quintile remained in one of the top two quality quintiles after three years.

The reverse was also true. The dearth of companies in the analysis that migrated from lower- to higher-quality quintiles over time underscores the disappointment felt by optimistic investors who predict a turnaround that fails to materialize. On average, over half of the companies starting out in the bottom quality quintile remained in the bottom two quality quintiles after three years. An important implication of quality persistence is that investors should focus on identifying and owning shares in high-quality companies at the right price rather than trying to identify the rare home run a company that moves from third-rate to first-rate. Those companies that do emerge do not compensate for the high proportion of those that do not.

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Conclusion
Our study affirms the investment rationale for buying high-quality stocks at compelling valuations. Higher-quality companies do indeed create more value than average companies in the market. However, investing in quality without regard for valuation is not a winning strategy for driving alpha over time, as valuation is a significant driver oflonger-term investment performance. We believe owning companies that are both high quality and inexpensively valued is shown to be the best way to generate sustainable, long-term investment performance.

METHODOLOGY
We defined quality along three dimensions: threeyear average return on equity (ROE), volatility of the three-year average ROE and three-year average assets to equity. The data were standardized within each dimension to equivalent terms by calculating a z-score, or standard score, for each metric in order to create a single quality measure. The universe of companies was then broken into quintiles based on the quality score and rebalanced on a quarterly basis. Companies falling into the first quintile were defined as high quality companies. Trailing price-to-earnings (P/E) ratios were used as the measure for valuation. Companies were divided into quintiles based on their raw valuation scores. Those falling into the cheapest two quintiles were considered to be inexpensively valued or low P/E companies (two quintiles were used to ensure a sufficient sample size).

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Issued in the United States by MFS Institutional Advisors, Inc. (MFSI) and MFS Investment Management. Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS International (U.K.) Limited (MIL UK), a private limited company registered in England and Wales with the company number 03062718, and authorized and regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered office at Paternoster House, 65 St Pauls Churchyard, London, EC4M 8AB and provides products and investment services to institutional investors globally. Issued in Hong Kong by MFS International (Hong Kong) Limited (MIL HK), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the SFC). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and fund sponsor registered with the U.S. Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services to professional investors as defined in the Securities and Futures Ordinance (SFO). Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian financial services license under the Corporations Act 2001 in respect of the financial services they provide. In Australia and New Zealand: MFSI is regulated by the U.S. Securities and Exchange Commission under U.S. laws, and MIL UK is regulated by the U.K. Financial Conduct Authority under U.K. laws, which differ from Australian and New Zealand laws.

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MFSE-QUALVAL-WP-10/13 22309.5