MFS

Capability Focus
Month 2012
White Paper Series
October 2013
FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY
BUILDING
BETTER
INSIGHTS

Authors
Katrina Mead, CFA
Institutional Portfolio Manager
Jonathan W. Sage, CFA
Portfolio Manager
Mark C. Citro
Quantitative Research Associate
QUALITY AND VALUE
The essence of long-term equity returns
IN BRIEF
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 signifcant driver of long-term investment
performance than quality.
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.
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.
OCTOBER 2013 / QUALITY AND VALUE: THE ESSENCE OF LONG-TERM EQUITY RETURNS
FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY
2
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 signifcantly 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 beneft 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 signifcant. 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 signifcant
source of value for strategies not owning the most expen-
sive stocks during the initial fve 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)
High quality and low P/E
0%
100%
200%
300%
400%
500% 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 profle offered by high-quality characteristics such
as low fnancial leverage and consistent, higher returns, as
well as lower valuation.
OCTOBER 2013 / QUALITY AND VALUE: THE ESSENCE OF LONG-TERM EQUITY RETURNS
FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY
3
Exhibit 2: Consistency of outperformance
Rolling 5-year performance of high-quality, low P/E stocks vs.
universe spread (1975 2013)
-100%
-50%
0%
50%
100%
150%
200%
13 10 07 04 01 98 95 92 89 86 83 80
High quality, low P/E underperforms
High quality, low P/E outperforms
Sources: Compustat and MFS
Does the quality/value screen offer insights
about sectors?
We observed that fnancial services, utilities and com-
munications stocks were less likely to pass the quality and
value screens. This may be due to the low leverage
requirement of our quality defnition, as these sectors tend
to have relatively high fnancial leverage. Also, many utility
and communications companies had lower overall returns.
Aside from this observation, no other relationships were
apparent.
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 frst quintile of quality were
still in this quintile three years later. Furthermore, on average
two-thirds of companies that started in the frst quality
quintile remained in one of the top two quality quintiles
after three years.
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
Q1 Q1 and Q2
30%
40%
50%
60%
70%
80%
90%
13 09 05 01 97 93 89 85 81 77
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
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 frst-rate. Those companies that do
emerge do not compensate for the high proportion of
those that do not.
FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY
Conclusion
Our study affrms 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 signifcant 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 defned quality along three dimensions: three-
year 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 frst quintile were
defned 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 suffcient sample size).
MFSE-QUALVAL-WP-10/13
22309.5
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.
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