For years, stock investors have fixated on “style,” which means investing in “growth” or “value.” “Value” in this context is usually defined as buying stocks with low price-to-book or low price-to-earnings ratios. Some are now rethinking the very foundations of this framework as the return to value indexes continues to shrink (Chart A, below). Others are leaving behind simplistic notions of “style” investing and looking for all sorts of new factors to find performance. In our view, adding a multitude of new factors to the mix is also the wrong approach. The right perspective simply relates price to a few fundamental quality factors, and avoids looking merely at book value or earnings per share.

Chart A
S&P 500, S&P Growth, and S&P Value Index Total Returns
(March 1994 – November 2020)

What it Means to “Own Equity”

Stockholders own the equity, or leftover value, of a firm’s assets after obligations to others are settled. So long as the value of a company’s assets is worth more than the liabilities, stockholders are “in the money.” But, if assets’ value becomes worth less than debts owed when the debt comes due, default is in the cards. In that case, creditors assume ownership of the company’s assets while stockholders walk away with nothing.

Growth, Debt, and a Knife’s Edge

The best way to avoid such an outcome is to make sure assets are worth more than debts owed when they come due. And the best way to do that is to grow. To quote Bob Dylan: “If you’re not busy being born, you’re busy dying.” This idea is just as fitting for a business as a person. If a firm is not continually giving birth to profitable investments that grow the value of the enterprise, it is probably heading toward the exit.

And there is no better way of ensuring continued growth than by limiting the amount of debt while investing in profitable projects. When these things happen, the chances of default become remote, and it becomes more likely everyone wins. What happens when firms stay in business and value grows? Shareholders’ “leftover” share of a firm’s value compounds, creditors see loans repaid in full and on time, employees enjoy greater job security and opportunity, governments collects more tax revenue, and customers enjoy more choices in products or services. But, when the margin between a firm’s asset values and debts owed becomes thin, stock values can go on a wild ride, and all involved stand a good chance of losing out on a good thing.

In the losing case, when nobody knows what will happen next, the game becomes poised on a knife’s-edge. One mistake or one piece of good luck could decide whether a business collapses or recovers, and formerly steady share prices can start to trade like highly speculative options.  To avoid ending up on this knife’s edge, it is crucial to keep in mind that asset values must be worth more than debt. Maintaining a healthy margin between asset values and amounts owed provides financial flexibility, an especially valuable trait during hard times.

The Quality Dimension

For many years, the entire stock market has been viewed along a horizontal continuum from “value” to “growth.” Stocks trading at low prices to earnings or book value are considered “value” and the other half is considered “growth.” This framework has been long enshrined in institutional investment decision making. This systematic bias has, at times, lead to greater risk-taking, especially when debt levels are on the rise and stock prices are not adequately capturing risk.

An alternative and we think better, way of doing things is to add a “quality” dimension along a vertical axis (Chart B, below). Quality, being a more durable factor than value, is deeply rooted in the ability of a firm to remain in business as a going concern. Investment decisions, profitability of assets, and creditworthiness are essential to such flexibility. The price paid for an enterprise should be set against this backdrop of “quality.” This quality/price perspective is common in other areas like bond investing and we think stock investors evaluate equity investments the same way.

Chart B
Adding a Quality Dimension to “Growth / Value”

A Better Way

As the world piles on debt, we see quality and flexibility becoming increasingly valuable factors to consider. How cheaply a firm’s assets’ leftover equity value can be bought won’t matter much if the firm can’t remain afloat, after all. So, instead of buying “growth at a reasonable price,” we will look to buy “quality at reasonable prices.” Relating price to quality is the “first principle” of investing, and a framework for evaluating investments, therefore, should never focus on price alone.

Kevin R. Caron, CFA
Senior Portfolio Manager

Chad Morganlander
Senior Portfolio Manager

Matthew Battipaglia
Portfolio Manager

Steve Lerit, CFA
Senior Risk Manager

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income

Suzanne Ashley
Internal Relationship Manager

Eric Needham
Director, External Sales and Marketing

Jeffrey Battipaglia
External Sales and Marketing


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