By Philip van Doorn
Investing strategists have been highlighting the importance of owning “quality” companies in the current economic cycle.
But what are quality companies and can their definition be clearly outlined?
Louis Florentin-Lee and Barnaby Wilson, managing directors of Lazard Management’s International Quality Growth strategy, seem to have done so — and successfully — as you can see on this chart:
Florentin-Lee and Wilson, who are based in London, manage about $700 million in the International Quality Growth strategy, with $32 million in the Lazard International Quality Growth Fund /zigman2/quotes/206495693/realtime ICMPX -2.09% , which follows the same strategy and was established Dec. 31, 2018. The fund’s performance benchmark is the MSCI All Countries World x-USA Index /zigman2/quotes/216998571/delayed XX:899901 +0.34% .
The fund managers discuss several stocks held by the fund, below.
From the end of 2018 through Oct. 8, 2021, the fund’s institutional shares returned 77%, while the MSCI All Countries World x-USA Index returned 43%. That is excellent performance for an investment that is completely diversified outside the U.S. (All investment returns in this article include reinvested dividends.)
Investment firms including Blackrock have been touting quality stocks as interest rates rise and the Federal Reserve begins to taper its stimulus. For Blackrock, quality companies have stable cash flows and earnings growth, and can raise prices without squelching demand.
Seeking ‘exceptional businesses’
During an interview, Florentin-Lee explained that the strategy is to hold a portfolio of about 40 “exceptional businesses” for periods of five to 10 years. The managers believe those companies have competitive advantages, including high barriers to entry in a market, strong brands, pricing power and technology.
But the most important selection criteria are driven by the numbers: high returns on capital that are well above the companies’ cost of capital and expected to continue for many years.
“The combination of high returns on capital and reinvestment gives you this beautiful compounding that drives share prices,” Florentin-Lee said.
The high returns on capital are essential, Florentin-Lee said, because “the market generally applies the economic law of competition that says supernormal profits attract competition and capital, which ultimately drive returns on capital down.”
He doesn’t believe the phenomenon applies to all companies. “When companies beat the fade, they tend to beat the market,” he added.
So when the strategy’s managers select stocks for the portfolio, based on the recommendations of nearly 100 analysts covering various industries for Lazard, they also try to identify what Florentin-Lee calls “investment opportunities for them to turbo charge their growth,” while maintaining high returns on capital.
Two in China: Alibaba and Tencent
Given all the concern about China recently, in light of the bond payment default by Evergrande and the regulatory crackdowns on several industries, your first question about the Lazard International Quality Growth Fund might be how much of the portfolio is made up of Chinese companies. Wilson said the fund holds American depositary receipts of Alibaba Group Holding Ltd. /zigman2/quotes/201948298/composite BABA -2.32% and Hong-Kong-listed shares of Tencent Holdings Limited /zigman2/quotes/204605823/delayed HK:700 -3.01% , which together make up about 5% of the portfolio. (For Tencent, the ADR is /zigman2/quotes/207908563/composite TCEHY -1.13% .)
Wilson emphasized that the portfolio selections are centered around quality and not exposure to particular countries. When asked about the possibility that the U.S. will force the delisting of Chinese companies over the next three years because of the lack of compliance with the Security and Exchange Commission’s reporting requirements, he said: “I don’t think there is a case where the U.S. investors will lose their value,” because other investors would be ready to buy those shares.
Tencent has a diversified online business, including advertising, cloud services, social media and content distribution. It is the largest distributor of video games in China, which is a concern because of the government’s efforts to limit the amount of time children spend playing games online.