Reese On The "Quality-Value Synthesis"

Many of history’s best investors have been big proponents of investing in “quality” stocks — those that generate high returns on equity and assets, and strong, consistent margins. But Validea CEO John P. Reese says there is something very important to recognize when using quality metrics to pick stocks.

Reese writes in a column for Canada’s Globe and Mail that “a rather fascinating dynamic is at play within what I’ll call the ‘Quality-Value Synthesis’. It involves what happens when you separate the value and quality components [from an investment strategy].”Reeseites a research study from Research Affiliates that shows that the use of quality metrics by themselves does not tend to lead to higher stock returns. But, when quality metrics are applied to value stocks, they significantly enhance returns.

“Put simply, the Research Affiliates study found that investing in quality stocks is a winning formula — if you are looking at a universe of cheap stocks,” Reese says. “It’s not the only study to come to that sort of conclusion. In a 2000 research paper, for example, Joseph Piotroski, a professor at Stanford University (and another of the gurus I follow), found that low price-to-book ratio stocks outperformed the market as a group not because they were in financial distress and thus higher-risk, higher-reward plays (as many thought); instead the group outperformed because of a small number of big winners within it – which tended to not be in financial distress. Those big high-quality winners helped low-P/B stocks outperform the market as a group even though most low-P/B stocks were actually losers, Prof. Piotroski found.”

The bottom line, Reese says, is that most good strategies use both quality and value metrics. He offers 8 stock picks from the Canadian market that get high marks from his Guru Strategies because of their combination of value and quality.