Episode 1: Why Quality Matters in an Inflationary Environment

Alex Warren: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, and Aristotle Atlantic Partners, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor, registered under the Investment Advisors Act of 1940 as amended. Welcome to the Power of Patience, Aristotle’s podcast, where we share our views on topics actively explored by the investment teams and across the organization. I’m Alex Warren, product specialist at Aristotle Capital, and I’ll be your host. Coming up on today’s episode, we’ll be speaking with Aylon Ben-Shlomo, Managing Director and Client Portfolio Manager at Aristotle Capital. Aylon is responsible for some of Aristotle’s largest client relationships. If you enjoy the podcast, please like and share it on LinkedIn to help us spread the word. Today on the show, we’ll discuss what is quality, how Aristotle Capital thinks about quality from an investment standpoint, how Aristotle identifies quality companies, and why Aristotle believes investing in a diversified global portfolio of quality companies can provide inflation protection. Without further ado, let’s get started. Aylon, thank you so much for your time today. To lead off the discussion, can you introduce yourself and provide us a brief history of your role at Aristotle Capital?

Aylon Ben-Shlomo: Hi, Alex, and hi everyone listening to the podcast. This is my first time joining the Power of Patience, and hopefully the first of many. My name is Aylon Ben-Shlomo. I’m a member of the investment team here at Aristotle Capital Management in our Los Angeles office. I’m now in my sixth year with the firm, which is hard to believe. Time flies. And I’m one of 18 members on our investment team. And I was looking at it before I came in today. Collectively, we have nearly 400 years of industry experience, which is a staggering number, but when you average it out, it’s a little over 20. And so, we’ve been doing this for a long time. We’ve seen a lot of things, but there’s a lot of new to learn about, and hopefully we can share some of that knowledge today on the podcast. So, thank you for having me, Alex.

Alex Warren: Wonderful, thank you, Aylon. I’d love to dive right in. Can you talk a little bit about what quality means and how you think about it from an investment perspective?

Aylon Ben-Shlomo: Quality is an important term. It’s one that’s used a lot in our industry. Unfortunately, or perhaps fortunately for us, is that quality can mean different things and can be looked at in different ways by different people. In fact, it reminds me of a quote that’s often attributed to Albert Einstein, and it goes, not everything that can be counted counts, and not everything that counts can be counted. So, what does that mean? With respect to investing, it means that when we’re looking at quality, there are certain numbers that absolutely matter, but then there are certain items that don’t have numbers, but absolutely matter as well. What are some examples? Well, if you’re an index provider or a quantitative manager, you might define quality purely by return on equity, financial leverage or some type of measure of profitability. There are other factors or attributes that are not captured by those data points, things like, how have management teams behaved? How have industry participants reacted to changing environments? Those type of qualitative assessments can be just as, if not more important than data points that can be found in financial statements or on your Bloomberg terminal. So, quality is absolutely something that needs to be assessed from both the quantitative lens, and for lack of a better term, qualitative lens as well.

Alex Warren: Absolutely. No, that makes sense. Now, it sounds like quality in your opinion then is something that’s kind of in the eye of the beholder, given that, like you said, not all the attributes are fully quantifiable. How important is quality to your investment process? And how does Aristotle differentiate itself as a manager when investing in quality companies?

Aylon Ben-Shlomo: Quality is critical. Our process is rooted in three elements, quality, valuation and catalyst. You can think of it as a three-legged stool. We intentionally start with the quality of a business rather than the price that it’s being offered at. That’s one way to differentiate. We’re not running screens in the hopes that a backward looking, or if it’s forward looking, consensus-based metric will lead us to what is “statistically or optically” cheap. Instead, we operate with the mindset of a business owner and try and understand, what does this company do? What makes it unique? Why do customers choose to do business with them? Why are they able to earn a return over and above their cost of capital? And perhaps most importantly, why will that sustain going forward? Those are the things that we’re focused on when we’re trying to identify a quality business. Now, your point on it, being within the eye of the beholder is absolutely true. As a bottom-up fundamental research focus firm, we look at investment opportunities on a case by case, company by company basis. We do the same when assessing quality. For example, there are some businesses where high margins, gross margins, for example, are critically important when trying to assess quality. Pharmaceuticals come to mind, software companies come to mind. Their high margins translate to high free cash flow and high returns on invested capital, elements that we would all agree on as being signs of high quality. On the other side of the margin spectrum, though, our companies like food distributors or grocery stores, they operate at razor thin margins, but their high asset turnover allows them to earn very attractive returns on invested capital in the mid double digits, sometimes even high double digits. That is an important example that we’d like to share here to show that quality can’t be just one formula. It must be understood on a case by case or company by company basis.

Alex Warren: Let’s talk a little bit about the macro picture with inflation in the developed markets at the highest level in roughly 40 years, it’s top of mind for many investors. How do you think about inflation within your fundamental investment framework?

Aylon Ben-Shlomo: Inflation, macro, two of my less favorite topics, but nonetheless important items to discuss, especially as we sit here today recording on December 8th. Like you said, Alex, inflation is running at 40-year highs nearly. For us, we are a bottom-up fundamental manager. We’re focused on companies one by one, piece by piece, but we can’t ignore the macro, and we have to consider inflation. When we look across the developed world, areas like the U.S. and Europe have seen inflation moderate slightly recently, but places like Japan are seeing inflation really much lower than other places like the U.S. I believe Japan’s running at around 3%. The U.S. and Europe are running, let’s call it around 8%, pick your metric. So, a pretty big difference, and I will come back to that in a moment. On inflation, it’s important to recognize that not all inflation is created equal. And when we assess companies, not all cost structures are created equal. So, what matters for one business in terms of input costs might not matter as much for another. Those of us who are paying attention to markets these days will recognize that there has been a bit of a shift. Inflation was running very high because goods were more expensive. There were supply demand imbalances throughout 2020, 2021. Now, things are shifting back more towards services. We’re able to fly places, we’re able to see our family, experience “normal life” more, and so services are becoming more expensive. That shift is an important thing to consider, and I’ll come back to my company examples. So, when we analyze businesses, if we’re looking at a manufacturing company, let’s say a farm equipment manufacturing company, they make tractors, things like steel and aluminum will be very important items to consider in the cost structure. Labor too, but steel and aluminum much more. So, when we analyze that business, we’re going to try and understand that piece of the cost structure much more than say a global consulting business. If we’re analyzing a global consulting business, the price of steel and aluminum won’t matter as much. However, the price of labor, the availability of labor will. And so, a point I’d like to make on inflation is that one thing we’re seeing and we expect to continue is that historically, raw materials, things like steel and aluminum, their inflation has been more cyclical and mean reverting. However, things like labor, wages, that inflation is much stickier.

Alex Warren: Aylon, you made a great point about how Japan has been an outlier when it comes to inflation. Can you dig in a little more into how you think about Japan within a global portfolio?

Aylon Ben–Shlomo: We believe Japan is a rather attractive area to invest today. We’ve believed that for a long time, but in the current environment, the inflationary divergence between Japan and places like Europe and the U.S. is rather stark. We’re talking five 6% differences in inflation rates, and that matters when one is focused on a real earnings yield. When we take a step back and look at how Japan, relative to other places, has responded to the COVID environment, it’s really rather stark. Japan is effectively just now opening up. They’ve been closed for about two years. Things like tourism have really not gone on. That’s about to start. In fact, it is starting. They’re obviously a bit more reliant on Chinese travelers, and as we know, that has not happened. So, Japan has experienced lower inflation than the rest of the world, and they’ve been locked up a little bit longer than the rest of the world. And so, when we look at the investing landscape at Japan, it’s underperformed much of the rest of the world over the trailing decade or so, and it’s gotten to a point where the waiting of Japan in the MSCI World or ACWI indicies, I believe is at or near its all-time low.

Alex Warren: Wow. Wow.

Aylon Ben–Shlomo: That’s typically a good time to invest in an area. We can think back to energy in global markets or here in the U.S. Energy reached an all-time low of the S&P 500. I believe it was in late 2019. We know what’s happened since then. Just like Howard Marx has a great quote, “Trees don’t grow to the sky,” and the waiting that we’ve seen, the overreactions that we’ve seen perhaps in some industries on the upside and the downside, Japan stands out as something similar. And in our portfolios, we believe we’re able to access just as high a quality, if not higher quality, in Japanese headquartered companies that are global leaders in their industry. So, you can think of a few, and our compliance team would hit me on the head here if I started naming them all, but they’re oftentimes Japanese companies that are trading at maybe 50% of the valuation of their U.S. peers, yet their fundamentals, their data would suggest that they’re just as good of quality. So, to us, that’s an attractive opportunity.

Alex Warren: Absolutely. No, that makes sense. Now, I know you don’t enjoy macro, so let’s move away from that and let’s go back to your bottom-up focus. Can you discuss any attributes you believe believer important in identifying high-quality companies that may be better protected in an inflationary environment like the current one?

Aylon Ben–Shlomo: Pricing power immediately comes to mind. It’s kind of the holy grail. I’m sure a lot of listeners have heard about it and know what it is. When you can find a company that does something that its customers want, whether it be a good or service, they’re typically able to pass on cost increases, pass on those cost increases over and above what they receive from their suppliers, and therefore create a virtuous cycle of increasing free cash flows and increasing return. So, pricing power immediately comes to mind. One of the ways that you can test for that… Because unfortunately, it’s not a data point that is in annual reports. People don’t publish their pricing power each year, but you can look at things like gross margin. That can oftentimes be a sign of pricing power. And one of the things that we like to do is, if we can find two companies that do the exact same thing, maybe it’s selling diapers or selling beer, if they do the exact same thing but they earn different returns, they earn different gross margins and they can sustain those through different economic times, that’s often a sign of pricing power. So, that’s an area that we look. There is of course a plethora of other items that we’re assessing and can be signs of quality, whether it’s scale brands and tangible assets, things like network effects, switching costs, recurring revenue, barriers to entry. It could go on and on. There really is a litany of items. And like I mentioned before, there’s no one formula. There’s no magic equation that we follow, and it’s very much a mosaic approach, if you will, to understanding what makes a business unique, what makes their competitive advantages sustainable, and what therefore makes it a quality company in our eyes.

Alex Warren: Aylon, this has been an interesting conversation. We have time for one more question though. Taking a step back, how do you think about quality from the portfolio level?

Aylon Ben-Shlomo: Yeah. There’s two lines of defense in our eyes. There’s at the company level and at the portfolio level. And so of course it’d be great if we could always find the best business at the most attractive price with lots of compelling catalysts that can not only survive but thrive in difficult environments of high inflation or something else, but the reality is it just doesn’t work that way, and so we need to diversify at the portfolio level. And that’s why, in our portfolios, we try and own companies, again, not only that can stand on their own two feet, but offer a balance and can diversify things like inflation shape of the yield curve, geopolitical risks, or other factors. Hopefully we can diversify that out when we’re constructing the portfolio. Different industries have different exposures to inflation, like I mentioned. And so some might be vulnerable to raw materials, some might benefit from raw material increases, and that’s where, at the portfolio level, we’re adding in individual companies that interact well with each other, and again, can diversify away. We believe that constructing a diversified portfolio of high-quality companies can help insulate the portfolio from inflation or other factors. We start with quality at the company level, and we finish with quality at the portfolio level. It’s a recipe that has served our clients well, and it’s a recipe we’ll continue to follow for the years and decades ahead.

Alex Warren: Beginning and ending with quality. I think that’s also a great way to end the episode. Aylon, thank you so much for joining us today. We hope you enjoyed it and you learned more about Aristotle. Thank you for listening to the Power of Patience. To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed the episode, please rate and review us on Spotify and Apple Podcasts and come back next time for discussion on cybersecurity with Aristotle Capital’s John Quan, Managing Director and Chief Technology Officer. Until then, this is Alex Warren, and thank you for listening.