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The king of quality

Jinesh Gopani, Head of Equity, Axis Mutual Fund talks about the key determinants of quality and why valuations matter

The king of quality

Axis Mutual Fund is known for having a focus on quality stocks. We spoke to Jinesh Gopani, Head of Equity, Axis Mutual Fund to find out what the key determinants of quality are and also how much valuations matter in the case of quality stocks.

Equity investing has generated great wealth for investors in the past few decades. But many have also lost money. So what determines who does well?
Equity markets have been great wealth creators over the last 40 years. In absolute terms, the S&P BSE Sensex has generated about 300 times returns since its conceptualisation in 1978. However, only a handful of investors have been the beneficiaries of this wealth creation. Likewise, many perceived stock gems of old times are trading as penny stocks and, in select cases, have gone out of business. The wealth destruction in these stocks is difficult to measure. The moral for the story: while saving and investing is important, what assumes more importance is quality of investing.

So how would you define quality investing? What are some tangible factors you look at when picking stocks?
Since our inception in 2009, the core philosophy of the equity-investment process has been a steadfast adherence to quality. Now 'quality' is a very broad term when it comes to investing. Our approach to understanding the quality of a business connotes a combination of two sets of factors:

Quantitative factors

  • Strong return metrics [example, return on equity (ROE), return on capital employed (ROCE)]
  • Stable cash flows - a company should be able to fund its organic growth from internal accruals and use long-term capital and working capital efficiently
  • High profitability, low debt-to-equity and earnings consistency

Qualitative factors

  • A strong management pedigree
  • Transparency of operations for investors and key stakeholders
  • Credible oversight committees and strong internal controls
  • A sustainable long-term business model

Clearly, this approach has worked for you. Can you explain how it plays out in different stages of the market cycle? What is the kind of research you do to ensure a company qualifies as a 'quality' investment based on the criteria you shared with us.

In aggregate, this style offers two potential advantages. First, quality has historically delivered a return premium, i.e., the opportunity to outperform a broad benchmark over the long term. And second, it offers a high margin of safety. Quality typically outperforms other investment styles during periods of turbulence as these stocks are considered as less volatile in relative terms by market participants due to their inherent fundamental attributes.

Being bottom-up investment managers, we pride ourselves in hunting for quality through diligent research. We pride ourselves on building index-agnostic portfolios with a long-term investment outlook. The market has rewarded quality and the growth style of investing for the better part of a decade now and we believe that consistent wealth generation will only happen if investors trust the businesses they invest in.

Our approach to quality involves an in-depth understanding of the businesses that we invest in. This process is twofold. Firstly, we evaluate the quantitative aspects like financials, past track record and other key metrics. Second and the most crucial is our interpretation of the qualitative aspects like management credentials and the potential of the business. Such an approach of ours has enabled our portfolios to ride out significantly volatile periods of the market.

What about valuations?
Given that value is subjective, ascertaining value is a critical element to investing and alpha generation. Companies like these are often investor favourites and are seldom available at 'cheap' valuations. The rationale is justifiable, given that these companies meet the three hallmarks - good managements, good earnings and transparency. So then where is the opportunity, you may ask? The opportunity lies in staying patient and alert at the same time - alert to any sharp falls in market prices to capitalise on short-term volatility in favour of long-term opportunity and being patient sometimes over several years.

In conclusion, quality has been an all-weather wealth creator for long-term investors despite several blips in performance. While uncommon, these blips in performance have not eroded the wealth created during the market upswing. Further, it is important to note that companies labelled as quality are fundamentally driven rather than by sentiment and hence the volatility quotient of these stocks remains relatively lower as compared to momentum and value-driven stocks where asset-pricing is dependent on subjective factors.