Lower interest rates to challenge current market thinking; but focus on quality essential

1 November 2012; Independent Australian investment management company, Dalton Nicol Reid has reached an important milestone, producing ten years of positive returns and no years of negative returns for its investors.

Dalton Nicol Reid is a boutique, quality-focused, Australian Equities and LPTs investment manager, which invests on behalf of its clients via Separately Managed Accounts (SMAs), Individually Managed Accounts (IMAs) and institutional mandates. The group has produced a total return of 11.5% over ten years, against a benchmark of 8.6% from October 2002 to present. Over three and five years, returns are 3.5% (benchmark: 1.8%) and 0.5% (benchmark: -3.5%) respectively.

CEO and Director, Harley Dalton said although the majority of its clients were retail and SMSF investors, it was now receiving increased demand from institutional investors.

“The investment and support teams are extremely proud of these results, which are testament to the depth of insight of our management team, during what has been an extremely difficult time for investors,” he said. “Our investment approach has been well received by both retail and SMSF investors. However, we are increasingly finding traction in the institutional market, so this milestone is an important signifier of the longevity of our investment approach.

Looking at the investment landscape ahead, Jamie Nicol, Dalton Nicol Reid Chief Investment Officer, said that the low interest rate environment will make cyclical stocks, such as industrial, housing, retail and media, more attractive as economic pressures ease. However, investors must focus on identifying quality, rather than simply relying on an overall improvement in market conditions, given the on-going structural issues in the sectors.

“Domestic defensive stocks have had a good six months, but we now believes these securities are mostly fully priced. With easing economic pressure, by way of lower interest rates, it’s now time to look at cyclical stocks that can benefit from an increase in spending from business and consumers,” he said. “But investors need to focus on understanding the quality of the company and sector, rather than just looking for cheaply priced stocks.”

Dalton Nicol Reid uses a five-point quality matrix to identify relative quality of listed companies. This includes balance sheet assessment, industry structure, management, earnings strength and ESG (environmental, social and governance). Mr Nicol said there is a growing body of evidence that supports ‘quality’ investing.

“Research on quality investing has largely focused on the back testing of various quality screens to determine the impact of quality on returns. On the whole, this research has shown a strong linkage between quality and performance over the medium and long term.

“A quality portfolio will be agnostic to value or growth and moves away from size bias, given both small and large companies might have quality attributes. Following a quality investment approach allows us to identify companies that are mispriced by overlaying this quality filter with a strong valuation discipline. It also allows us to enhance returns by identifying companies when they are out of favour.”

Mr Nicol said: “A two tiered economy has been operating for the past few years with resources leading the way. The overall economic growth is likely to stay positive in the next few years but we believe the domestic industrial sector will start to drive some of this growth as the resource sector slows.”

“We also see interest rates as remaining low. This will have a number of implications for investors. With bond yields at lows, companies with sustainable profit growth will be more attractive. Retirees will chase yield, so shares that deliver dividends will be likely to attract flows from this group and pressure will ease for domestic cyclicals.”

Looking ahead for the business, Mr Dalton said; “Roughly one quarter of our FUM is invested on behalf of institutional investors. Dalton Nicol Reid is reviewed by institutional asset consultants and has also received strong ratings from research houses. A lot of institutions, particularly super funds have reduced the number of managers they hire and are focusing more on passive and index investments. As a result, any active managers chosen need to be proven alpha generators with high conviction ideas.

“Given our investment approach and proven track record managing concentrated portfolios, Dalton Nicol Reid is well positioned to take advantage of this change.”


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About Dalton Nicol Reid

Dalton Nicol Reid is an independent Australian investment management company that delivers client-focused, quality investment solutions to institutions, intermediaries and high net worth investors. The basic foundation of the business is to put clients’ needs first and provide them with an unparalleled level of service, be they institutions or individual investors.

Dalton Nicol Reid has a rigorous investment process proven through various market cycles and its client-oriented Individually Managed Accounts (IMAs) and Separately Managed Accounts (SMAs) solutions are pioneering developments within Australian financial markets.


About Quality Investing

In Dalton Nicol Reid’s view, the following reasons help explain why quality companies outperform:

  • Quality companies generate more capital that can be reinvested to drive sustainable returns over time. This can be achieved via appropriate deployment of capital either internally or via M&A.
  • Companies in structurally superior industries with pricing power can grow above CPI and are more protected against inflation.
  • Higher quality balance sheets help to ride out cycles.
  • The ability to value quality companies is enhanced by the sustainability of earnings. So quality companies will tend to trade at a premium.
  • Quality companies tend to recognise the benefits of good ESG policy. As financial analysts tend to ignore ESG risks in terms of valuing companies and identifying risks, these benefits are often understated.

The concept was first recognized in the 1930s by Benjamin Graham, who classified stocks as either high or low quality. Mr Graham found that the greatest losses resulted not from buying quality at an excessively high price, but from buying low quality at a price that seemed good value.

Another celebrated study was by conducted by University of Chicago Accounting Professor, Joseph Piotroski (2000) who reasoned that because value stocks are by definition often troubled companies, many will not possess the financial resources to recover. Consequently, Piotroski wondered if it was possible to improve the performance of a value stock portfolio by eliminating stocks that were the weakest financially.

Piotroski devised a simple nine-criteria stock-scoring system, called FSCORE, for evaluating a stock’s financial strength that could be determined using data solely from financial statements. His findings were that these strong stocks as a group outperformed a portfolio of all value stocks by 7.5% annually over a 20-year test period. Piotroski also found that weak stocks, scoring two points or fewer, were five times more likely to either go bankrupt or delist due to financial problems.

The Piotroski’s scoring system gave one point if a stock passes each test and zero if it did not. The basis was as follows:

  1. Net Income: Bottom line. Score 1 if last year net income is positive.
  2. Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.
  3. Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.
  4. Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.
  5. Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)
  6. Current Ratio: Measures increasing working capital. Score 1 if CR has increased from the prior year.
  7. Shares Outstanding: A measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.
  8. Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.
  9. Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.