"Why Quality matters": Q&A with Aidan Farrell, Director of Global Small-Cap Equity at Eaton Vance August 2019

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We first caught up with Aidan in 2017 to hear about Eaton Vance’s approach to small-cap equity investing and about his early interest in finance. Two years later, we are back checking in to discuss in more depth the critical “Quality” pillar in the team’s Quality, Valuation and Time (QVT) investment philosophy as well as the steps in Eaton Vance’s team-based approach. We also get to share Eaton Vance's recent white paper .

To start, how do you define "Quality"?

When we talk about Quality, we are speaking about a specific set of company characteristics. These include:

• Well-entrenched franchises
• Durable and scalable business models
• Beneficiaries of structural growth and/or change
• Strong management teams
• Healthy balance sheets

Where does Quality fit within your QVT investment philosophy?

The Valuation and Time elements are vital to our QVT investment approach, but Quality is the cornerstone. Why is it so important? Well, as small-cap investors, our aim is to manage portfolios that are well positioned for both capital preservation and capital appreciation and investing in companies that we believe are of high and/or improving Quality is essential for this. In our experience, Quality companies are better able to maintain or grow market share (even in down cycles), while also exhibiting better downside protection. This combination is critical for achieving better risk-adjusted returns through the economic cycle.

When the team has identified a Quality company, what comes next?

Once we’re confident that we’ve found a company of requisite Quality, we’re only partly through the decision-making process. Determining whether to add the company will be dictated by two additional factors: a) the current Valuation (are the company’s prospects already priced in?); and b) Time, where we assess whether any other factors are forestalling action on taking that position now. Time is essentially the discipline of exercising patience — patience on entry points, patience on holding periods and patience as it relates to the long-term nature of our investment mindset.

If we are satisfied that all three inputs – Q,V and T – are aligned, the company will be added to the portfolio at an appropriate risk position size. However, if we have identified a company of sufficient Quality, but the V and/or T factors are not aligned, the company is then formally added to an investment wish list where it will be monitored closely for a more suitable entry point.

How have Quality and Valuation factors performed historically in the global small-cap sector?

In addition to what we see in the companies we invest in, we’ve actually undertaken proprietary research into this area. The research shows that Quality and Valuation factors have exhibited strong alpha-generating potential across the small-cap universe historically.

For our analysis, we used Return on Invested Capital and Return on Equity as Quality markers and included Free Cash Flow Yield as the Valuation marker. We then divided the MSCI World Small Cap Index constituents into quintiles based on these fundamental indicators and found that stocks with relatively high scores for Quality and Valuation (i.e., less expensive) significantly outperformed over 2000 to 2018, with higher annual active returns for the top two quintiles. Conversely, the lower-quality and costlier stocks in the bottom quintiles significantly underperformed.

We explored these findings in our recent white paper: Distilling stock-level alpha in global small-cap equities

Are there any regions within the global small-cap universe where you find higher numbers of Quality companies?

The beauty of this asset class is that Quality companies exist across the entirety of the investment universe. As bottom-up investors, however, the key for us is to have the right team and the right process in place to exploit these opportunities. With 15 investment professionals spread across London, Boston and Tokyo, we think we have a distinct advantage in having a local presence for undertaking research in these markets. The overall team is also highly experienced, with an average of 14 years working in the financial industry.

A common QVT investment philosophy, process discipline and a culture of collaboration ensure an integrated investment approach. We believe that the strong risk-adjusted performance of our global small-cap strategy, which will celebrate its four-year anniversary this August, attests to the success of our approach.

Lastly, Europe has been hit by record temperatures this summer. How are you beating the heat?

Fortunately, I’ll be taking advantage of the good weather to sneak away for some quality family time and holiday in the Canary Islands and on the south coast of Ireland. Other than that, I’ll be staying closer to the air conditioning unit than usual.

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