The Quality Quotient in Long-Term Alpha

Linking earnings power, financial stability, and competitive moats to results

Investors are generally taught that highly concentrated portfolios mean taking on more risk, but that may not always be the case. In our experience, the perceived risk of holding a concentrated portfolio can be offset by owning high-quality investments. By owning a concentrated portfolio containing only the highest quality companies, investors can potentially take meaningfully less risk than the market while generating greater long-term performance.

Data shows that owning financially superior and competitively advantaged businesses can offer a margin of safety in almost any market. By seeking to build active, quality growth portfolios containing no more than 20 to 35 of what we think are the best businesses globally, we believe we are favorably positioned to generate sustainable, above-average earnings over the long term.

A Powerful Differentiator: Quality at the Market Level

Markets have shown how quality can be a powerful differentiator. We examined the performance of the MSCI USA, ACWI, ex-USA, and Emerging Markets Quality indices. These indices, which are mechanically constructed around three objectively defined fundamental factors, have outperformed their broad market counterparts over the long term and, in our view, illustrate how even modest improvements in portfolio quality can be worthwhile.

MSCI Quality indices select the top 20% to 30% of U.S. and international companies using three measures: high return on equity, low financial leverage, and stable year-over-year earnings growth.

MSCI’s fundamental factors of quality

  • Return on equity (ROE): Measures a business’s profits relative to the equity its shareholders have contributed.
  • Debt-to-earnings (D/E) ratio: Evaluates a business’s debt level.
  • Earnings variability: Identifies earnings stability over time.

The historical performance differentials between MSCI’s broad market indices and the MSCI Quality indices across geographies and investment horizons provide, in our view, a strong case for owning quality, shown in Figure 1. Over 15 years, MSCI USA, ACWI, ex-USA, and Emerging Markets Quality indices provided a 3% higher annualized return on average—with less risk (as measured by Sharpe Ratio).

Figure 1: Quality vs. Broad Market Indices

Past performance is not indicative of future results. Data as of 9-30-2021. Source: eVestment. Data based on monthly returns.

For illustrative purposes only. MSCI USA, ACWI, ex-USA, and Emerging Markets Quality indices consistently outperform their broad‐based counterparts in absolute terms and when adjusted for risk (Sharpe Ratio). Sources: eVestment. Data based on monthly returns.

Setting an Even Higher Bar for Quality

Polen Capital has executed the same time-tested investment philosophy and process for more than 30 years. We think our process sets an even higher bar for quality by considering additional factors beyond MSCI’s standard quality fundamentals: ROE, debt-to-equity, and earnings variability.

Once we apply our five investment guardrails to identify the quality universe of companies, we layer on additional research and our careful stock selection process to build a portfolio that we think offers long-term staying power.

What we look for in a business: Five guardrails needed to invest

    1. Strong balance sheet with little to no debt and net cash
    2. High ROE
    3. Better than average earnings/free cash flow
    4. Stable or widening profit margins
    5. Real, organic revenue growth

These guardrails mark the beginning of our process by identifying the universe of quality companies. From this pool, we select what we think are the best candidates for additional research and possible inclusion in a portfolio seeking to deliver outsized returns with minimal risk. We also integrate material ESG factors into our process—assessing risks based on materiality through the lens of all company stakeholders. Evaluating ESG factors is a natural part of our overall process of considering all material risks and opportunities, and we believe a core component in assessing long-term resiliency and stability.

Quality as a Safety Net Even in Challenging Markets

We believe investing exclusively in growing, well-managed companies with strong balance sheets offers a smoother path to returns across market environments. In periods of market decline, earnings stability and financial strength can serve as a “margin of safety” that typically offers resilience amid downturns. Characteristics like earnings power, financial stability, and competitive moats can allow companies to weather tougher times and can enable them to power through a crisis faster and stronger than competitors.

Consider the performance across four geographic universes: U.S., global, international, and emerging markets. Figures 2-4 depict the growth of $100 across three crisis environments for the MSCI Quality Indices, Broad Market Indices, and applicable Polen Portfolios where available. In all three scenarios—the Tech Bubble, the Global Financial Crisis, and the COVID-19 Crisis—quality better protected capital and rebounded stronger than the broader market. For the COVID-19 Crisis in particular, we acknowledge this represents a short period of performance, with the drawdown and recovery occurring within an unusually compressed window. The COVID-19 recovery across regions has been ongoing and uneven to date. Longer term, we expect that Polen’s higher bar for quality will continue to provide a clearer path to compelling long-term outcomes.

Figure 2: COVID-19 Crisis

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns. Current performance may be lower or higher. Please reference the following GIPS reports: Global Growth, International Growth, Global Emerging Markets, Focus Growth. Source: eVestment. Data from 12-31-2019 to 9-30-2020 and 1-1-2020 to 9-30-2020.

Figure 3: 2008 Global Financial Crisis

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns. Current performance may be lower or higher. Please reference the following GIPS reports: Focus Growth.  Source: eVestment. Data from 12-31-2006 to 12-31-2009.

Figure 4: Tech Bubble

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns.  Current performance may be lower or higher. Please reference the following GIPS reports: Focus Growth.  Source: eVestment. Data from 12-31-1999 to 12-31-2003.

By focusing on identifying quality companies that have the potential to weather challenging market environments, we believe we can provide a favorable foundation for our portfolios to generate attractive relative performance. Our time-tested investment process is reinforced by our more than 30 years of data and research that we think shows concentrating on quality, principal protection, and long holding periods are key characteristics of a strong investment discipline that can work over time and across geographies.


Important Disclosures
Past performance does not guarantee future results and profitable results cannot be guaranteed. There can be no assurances that any portfolio characteristics depicted herein shall be replicated in the future. Returns are presented gross and net of management fees and have been calculated after the deduction of all transaction costs and commissions and include the reinvestment of all income. Net of fee performance was calculated using actual management fees.

This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of October 2021 may involve a number of assumptions and estimates which are not guaranteed and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness, or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.

The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved by an individual investor. In addition, an investor’s holdings may be materially different from those within the index. Indices are unmanaged and one cannot invest directly in an index.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 618 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

The MSCI ACWI captures large and mid cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 2,470 constituents, the index covers approximately 85% of the global investable equity opportunity set.

The MSCI ACWI ex USA captures large and mid cap representation across 22 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 2,137 constituents, the index covers approximately 85% of the global equity opportunity set outside the U.S.

The MSCI Emerging Markets Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world and captures large and mid-cap representation across 27 emerging markets countries. The MSCI Emerging Markets Index is maintained by Morgan Stanley Capital International.

The MSCI Quality Indices are based on their respective parent indices. The quality indices aim to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.

Sharpe ratio is a ratio of the return on an investment relative to its risk.