The “Science” and “Art” of High Quality Investing

• Author: Rohan Dhanuka,Dan Hanson
• Date: 01 June 2015
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jacf.12120

VOLUME 27 | NUMBER 2 | SPRING 2015

APPLIED CORPORATE FINANCE

Journal of

In This Issue: Sustainability and Shareholder Value

Meaning and Momentum in the Integrated Reporting Movement 8Robert G. Eccles, Harvard Business School,

Michael P. Krzus, Mike Krzus Consulting, and

Sydney Ribot, Independent Researcher

Sustainability versus The System: An Operator’s Perspective 18 Ken Pucker, Berkshire Partners and Boston University’s

Questrom School of Business

Transparent Corporate Objectives—

A Win-Win for Investors and the Companies They Invest In

28 Michael J. Mauboussin, Credit Suisse, and

Alfred Rappaport, Kellogg School of Management,

Northwestern University

Integrated Reporting and Investor Clientele 34 George Serafeim, Harvard Business School

An Alignment Proposal: Boosting the Momentum of Sustainability Reporting 52 Andrew Park and Curtis Ravenel, Bloomberg LP

Growing Demand for ESG Information and Standards:

Understanding Corporate Opportunities as Well as Risks

58 Levi S. Stewart, Sustainability Accounting Standards

Board (SASB)

ESG Integration in Corporate Fixed Income 64 Robert Fernandez and Nicholas Elfner,

Breckinridge Capital Advisors

The “Science” and “Art” of High Quality Investing 73 Dan Hanson and Rohan Dhanuka,

Jarislowsky Fraser Global Investment Management

Intangibles and Sustainability:

Holistic Approaches to Measuring and Managing Value Creation

87 Mary Adams, Smarter-Companies

Tracking “Real-time” Corporate Sustainability Signals

Using Cognitive Computing

95 Greg Bala and Hendrik Bartel, TruValue Labs, and

James P. Hawley and Yung-Jae Lee, Saint Mary’s

College of California

Models of Best Practice in Integrated Reporting 2015 108 Robert G. Eccles, Harvard Business School,

Michael P. Krzus, Mike Krzus Consulting, and Sydney Ribot,

Independent Researcher

Journal of Applied Corporate Finance • Volume 27 Number 2 Spring 2015 73

The “Science” and “Art” of High Quality Investing

* The authors would like to thank Don Chew for invaluable editorial guidance, and

thanks to our colleagues at Jarislowsky, Fraser Limited, and Columbia University for helpful

comments.

1. Frederick L. Muller and Bruce D. Fielitz, “Standard & Poor’s Quality Rankings Re-

visited,” The Journal of Portfolio Management, Spring 1987, Vol. 13, No. 3.

T

Life is not an exact science, it is an art.

– Samuel Butler

here is a long tradition of investing in “quality”

companies, one whose best-known modern prac-

titioner is Warren Buett, but which dates back

to Benjamin Graham in the 1930s. But despite

the length of its pedigree, and the respect commanded by its

most successful practitioners, neither the academic literature

nor investors have reached agreement on a clear denition of

quality. Denitions are wide-ranging and, in some cases, even

contradictory.

In this paper we explore the concept of “high quality

investing.” First, we review the “science” of approaching quality

via nancial statement and market performance measures. We

review some widely known measures. We note that many

of those widely known measures have been studied from

an academic rather than practitioner perspective. Secondly,

we further examine those widely used measures from the

perspective of the long-term investor in today’s market. We test

for the persistence, and long-term performance implications,

of these “scientic” measures. irdly, we review the “art” of

approaching quality via qualitative measures including culture

and ESG metrics. Finally, we propose that a combination of

“science” and “art” is a promising approach for practitioners

and researchers alike.

e traditional “Blue Chip” quality investment practitio-

ner tends to recognize quality in the form of high ROEs, low

debt, and stable earnings. is framework is consistent with the

view that “quality” is the opposite of “junk,” which is charac-

terized by cyclical protability, highly leveraged balance sheets,

and erratic earnings streams. Another take on quality—one that

came into vogue after the TMT bubble of 2000—is the view

that “quality” is the opposite of “aggressive growth.” In contrast

to aggressive growth rms, quality companies generate large and

fairly predictable free cash ow—that is to say, far more cash than

they reinvest in the business—and are known to have disciplined

capital allocation, management, and governance structures.

In addition to these traditional indicators of quality, academ-

ics in nance and accounting have produced research during the

past two decades that has provided the basis for “accounting”

measures of quality that attempt to classify companies according

to the quality of their earnings. But whereas traditional versions

of high quality tend to emphasize stable earnings, the more

recent accounting research—and the investment strategies that

have come out of it—begin with the recognition that the illusion

of earnings stability can be created through practices known as

“earnings management.” e underlying premise of these studies

and investment approaches is that high quality managements

care more about producing operating cash ow and “economic

earnings” than reported accounting earnings; and to the extent

this is so, more volatile or lumpy reported earnings can actually

be a reliable indicator of corporate integrity and a management

culture committed to transparency.

Financial statement measures of quality are by their

nature backward-looking. e S&P Quality scores have been

published since 1956, and award high scores to companies with

low earnings volatility and consistent, non-cyclical earnings and

dividend growth. Studies have shown favorable returns to high

(but not the very highest) quality buckets.

1

Take a business like

Philip Morris, which satises the S&P high quality criteria and

which Jim Collins identied as “great” in his business bestseller

Good to Great. On nancial statement criteria, Philip Morris—

with strong brands supporting predictable, non-cyclical earnings

and stable dividend payouts—is a poster-child for many models

of high quality. However, for many investors, the negative health

implications of cigarettes, the company’s violation of the public

trust (which culminated in the $206 billion industry settlement

in the U.S. in 1998), and the negative volume trends of the

underlying business, stand in stark contradiction to a notion

of high quality.

Some investors look explicitly to ESG criteria to identify

high quality busi nesses. By incorporating environmen-

tal, social, and governa nce practices into business analysis,

investors are incorporating a for ward looking perspective that

includes a view on future customer relevanc e. As an example,

David Swensen, Yale’s chief investment ocer, recently wrote

to Yale’s external managers that “…consideration of the risks

associated with clim ate change should produce higher-quality

by Dan Hanson and Rohan Dhanuka,

Jarislowsky Fraser Global Investment Management*