Investing in Quality

Research suggests that higher quality stocks tend to outperform lesser quality peers over the long run. But what does “quality” actually mean in this context?

According to the Oxford Dictionaries, the word is defined as “the standard of something as measured against other things of a similar kind; the degree of excellence of something.” But as with other such descriptives, it can—and often does—mean different things to different people.

That said, there seems to be some measure of agreement about what it signifies with respect to investing. “Quality” refers to those investments that have a higher probability of meeting return objectives than randomly selected alternatives, generally with less risk than the broader universe of comparable investments. In other words, they exhibit a measure of consistency and stability that tends to garner a premium in an inherently unpredictable world.

Quality is not all that matters, of course. In fact, investments that fit this description may not be worth buying at current prices. Investing in quality stocks, for instance, only makes sense if the shares can be acquired at a cost that is attractive relative to current and expected returns and prospects.

But, first things first. In determining quality, it helps to outline the factors that have, historically at least, served to separate the wheat from the chaff. In the equity market, one differentiator has been some combination of competitive advantage and high barriers to entry. If a company has cost or pricing advantages, it will likely earn superior and steady returns on capital for extended periods of time. If it is difficult for new competitors to enter the marketplace, these advantages will likely be sustainable. While not guaranteeing a positive outcome, these attributes imply greater earnings predictability and reduced risk of negative surprises, which has a value to investors.

The notion of what constitutes a competitive advantage can be somewhat nebulous, depending on the industry involved, operating environment, and other factors. Although books such as Michael E. Porter’s Competitive Strategy: Techniques for Analyzing Industries and Competitors offer useful road maps for identification and evaluation, the assessment process can be a Herculean task, even for those, such as corporate managers, who are close to the ground. Moreover, as a qualitative endeavor, it is naturally fraught with biases and risks.

Regardless, such an exercise can pay many dividends, including providing a better sense of the fundamentals that make a company—a quality company—tick. Among the questions worth asking:

  • Are customers willing to pay a higher price for a company’s products and services than for those of a competitor?
  • Can it deliver its products or services at a lower cost than its competitors or substitute products?
  • Do customers face a high cost or risk in switching from one supplier to another?
  • How expensive or risky is it for potential competitors to enter the market?
  • How might the circumstances referred to in the aforementioned questions likely to develop in future?

Even with an accurate evaluation of the competitive landscape, it makes sense to crosscheck qualitative assessments with quantitative data to try to verify a company’s sustainable edge. The latter category can include gross and operating margins on sales, and returns on assets and capital. If margins and returns have been consistently high relative to those of other companies or industries, it bolsters the view that a business enjoys a genuine advantage.

Investors may also wish to incorporate another method for assessing a company’s situation and prospects. Developed by the Boston Consulting Group (BCG) in the 1970s, the Growth Share Matrix seeks to evaluate businesses along two dimensions. The first describes the growth rate of the overall market, which approximates to it attractiveness. The second details a firm’s market share, which is a proxy for its profitability. BCG used this matrix to segregate businesses into four quadrants, as follows:

  1. “Stars”: large market share in a high-growth market
  2. “Cash Cows”: large market share in a low-growth market
  3. “Dogs”: small market share in a low-growth market
  4. “Question Marks”: small market share in a high-growth market

Not surprisingly, those who seek higher quality investments tend to favor businesses that fall into the first two categories.
 
It is one thing to have a competitive edge, but it is just as important to be able to sustain that edge. For a quality company, that means a strong balance sheet and positive cash flow, which enables the firm to meet most contingencies. Being faced with the prospect of having to exit profitable niches or markets due to temporary downturns or disruptions is not the hallmark of a well-run business.

To be sure, it’s not just cash-flow adequacy and an ability to handle regular obligations that matter. Historically, one thing that has made a company attractive to its customers—and, consequently, a quality investment—is the perception of financial strength. If customers need a product or a service, particularly components that are critical for their businesses, they would naturally prefer to deal with suppliers that have the wherewithal to provide ongoing support, even amid the worst of downturns.

This capability can be assessed in various ways. One approach, though not necessarily the best given the failures that became evident during the global financial crisis, is to ascertain the credit ratings assigned to the company by agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. Although their scales vary slightly, a grade equivalent to “A” or higher would likely mark the minimum threshold for a quality business.

Another, probably more reassuring method is to go directly to the financial statements. Among the questions to ask:

  • Does the balance sheet reveal a significant level of cash relative to current liabilities and the cost of running the business, especially in comparison to rivals and others in the sector?
  • Is the amount of debt outstanding small relative to balance sheet equity and free cash flow?
  • Is balance sheet equity appropriate in comparison to market capitalization?
  • Has historic operating cash flow consistently covered capital expenditures and financial obligations, and left room for consistent dividend increases and share repurchases?
  • Have revenues been expanding consistently, ideally at a pace higher than corresponding increases in nominal growth in the overall economy, without excessive volatility?

Potential trouble spots shouldn’t be ignored, of course. Established companies whose capital expenditures continually outpace depreciation expenses may be losing out to competitors or, perhaps, are simply in bad businesses. Firms that consistently increase debt relative to equity may have unsustainable operating models or are relying on aggressive financial engineering. Either way, they are unlikely to fall under the moniker of “quality.”

One thing that matters as much as—or perhaps more than—numbers, of course, is people. As with an evaluation of the competitive landscape, determining whether a company has the right kind of management can be a highly qualitative exercise—no pun intended—with severe limitations. Still, the executive suites of well-run businesses do seem to have certain things in common, including:

  • Experienced leadership, long tenures, a deep bench, and an orderly succession plan
  • Long organizational history
  • Clear sense of objectives and strategy
  • Willingness to push the business and its industry into the future

Not all of the criteria are subjective. Arguably, capital allocation is one of the most important functions that senior management is responsible for, and this can be measured. Performance can be judged by looking at returns on assets, equity and capital over time. Consistently high results are positive; high and improving returns are better.

In fact, if management has been able to invest retained earnings and achieve consistent or improving returns on assets, capital and equity, the firm is effectively firing on all cylinders. In other words, if it can expand its business using annual earnings and realize the same or higher return on that investment—at a time when the market is valuing the business at more than book value—that is a great deal for shareholders. The company makes a dollar, management invests it, and that dollar is immediately worth some multiple of that in market value.

It goes without saying that the management of a quality company should be oriented towards maximizing the long-term value of being a shareholder. If management is unable to invest profits at attractive rates of return, it should be able to articulate and implement a clear strategy for returning excess capital to its owners in the form of dividends or, perhaps, share buybacks.

However it is accomplished, an assessment of management strengths and weaknesses is a critical step in identifying a quality investment. Management drives the strategy of a business; they drive the implementation of that strategy; they drive capital allocation; and they drive returns to shareholders. It is hard to imagine a long-term success story without the right characters in charge.

Finally, another attribute that helps to define a quality business comes down to how it is perceived in the marketplace—by investors, employees, customers, suppliers and other stakeholders, including the community at large. More specifically, it should have trusted products and services and a highly regarded brand.

Once again, evaluating such perceptions can be a highly subjective process. However, it is possible to view relevant qualitative data in a more quantitative light. There are any number of surveys, for example, where investors and employees rank companies based on attributes such as trust and quality. Although the rankings in such surveys are probably not that material, the questions of whether a firm is on the list or not, and whether it is near the top or bottom, reveal a great deal. With few exceptions, perceptions about a firm, whether positive or negative, tend to be durable and difficult to destroy.

If the answers to these various questions about a company’s operating environment, financial condition, management and other factors describe a quality enterprise, it suggests that the downside risk, in relative terms at least, is limited. But that does not really address the question of upside. One could argue, of course, that if everyone knows a good thing when they see it, that faith will be reflected in its price. With that in mind, the biggest risk would seem to be in acquiring the investment at the wrong price.

That said, quality stocks have proved to be a good investment even for investors who are impatient or unwilling to wait for an optimal moment to buy—say, after a broad market decline or following an adverse swing in short-term sentiment. That is because quality companies have historically provided an extra cushion to shareholders in the form of increasing dividends or buybacks.

Acquiring the stock of a quality company, even at what many might view as the right price, is not the end of it. As with investing generally, the metrics used to initiate an investment should also be evaluated on a regular basis to determine whether the original thesis remains intact, while taking care to avoid confirmation and other biases. The benefit to this approach is that it provides the confidence necessary to stay the course and augment the exposure when opportunities present themselves. If the investment case is no longer valid, history suggests that investors in quality companies will have some time to formulate an exit plan.

In the end, of course, the future is unknowable and unpredictable, and no investment approach is infallible, including one oriented towards investing in quality. However, to reduce the risk of owning investments that will perform poorly, it seems to make sense to target those businesses with qualities that have traditionally worked for the benefit of shareholders.

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