What is Quality Investing?
Quality investing has become a hot topic in recent years. Not least because prominent investment managers such as Terry Smith (Fundsmith) and Nick Train (Lindsell Train) have delivered phenomenal investment success by implementing this strategy.
Quality investing is an investment style (like value and growth) that involves buying companies with exceptional characteristics.
Loosely defined, these are companies with a durable competitive advantage, or ‘moat’, established through some exclusive niche of theirs (brand, scale, product differentiation). This often makes them market leaders, extremely profitable, and highly cash flow generative.
Essentially, they are best in class businesses with an impressive track record that will stand the test of time.
Difference Between Value, Growth, and Quality Investing
Quality investing is a more subjective endeavour versus growth and value investing.
Financial metrics are usually enough to define a value or growth stock. Screening for a quality stock, however, requires a more holistic understanding of business fundamentals, its competition, and long-term consumer trends.
Professional investors argue that this is a necessary part of the stock selection process. They argue that the definitions of growth and value are too narrow and present a false dichotomy.
Warren Buffett stated as much in the 1992 Berkshire Hathaway annual report:
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth’…We view that as fuzzy thinking…Growth is always a component of value”.
A quality investor (like Buffett) believes that value and growth are inextricably linked. To quality investors, value isn’t just about having a low P/E multiple. It is about whether the market price offers a discount to intrinsic value.
In turn, intrinsic value is the present value of future free cash flows and the ability to grow these in the future. The combination of high returns on capital and plentiful sources of growth opportunities, mean that quality companies have significant scope to grow their free cash flow.
Moreover, the market consistently under appreciates quality traits. This is either due to short-termism or the assumption of mean-reversion, which means that quality companies frequently exceed expectations.
Therefore, the philosophy of quality investing is that the market undervalues superior franchises with exceptional economics long-term.
What is a Quality Company?
A ‘quality’ company is one that generates strong, predictable cash flows; sustainably high returns on capital; and consistent long-term growth.
These tend to be the hallmarks of companies with some well-established niche. A niche is anything that differentiates a company from its competitors in a way that’s difficult to replicate or disrupt.
Examples of niches include:
- Product Superiority
- Brand Strength/Loyalty
- Network Effects
- Patents
- Scale
- Technology Advantage
Warren Buffett refers to a company’s niche (or niches) as its ‘economic moat’. You can think of this as a hypothetical fortress protecting the business from external threats.
Essentially, niches create barriers to entry for competitors and keep consumers returning as repeat buyers.
This is otherwise known as having a competitive advantage.
Quality investing is about assessing the sustainability of a company’s competitive advantage, as those able to maintain their edge go on to deliver extraordinary results for their shareholders.
The mechanics work like this…
Companies with a durable moat stand the best chance of growing market share and achieving pricing power, which allows them to scale at high margins and returns on capital. By reinvesting any cash made back into the business, they can then compound at these high returns and drive sustainable, long-term growth in earnings and free cash flow.
This virtuous cycle of cash generation and reinvestment at high incremental returns to generate further cash is the essence behind quality companies.
Free Cash Flow Growth Requires Attractive Growth Opportunities
There is a caveat, however. For this cycle to persist, there needs to be a continuous stream of new growth opportunities. Terry Smith alluded to this in his 2021 annual shareholder letter:
“Consistently high returns on capital are one sign we look for when seeking companies to invest in. Another is a source of growth — high returns are not much use if the business is not able to grow and deploy more capital at these high rates”.
Therefore, quality companies tend to be geared into some secular (long-term) macro trend that complements their niche. This could be globalisation, aging demographics, disease prevention, climate change, or urbanisation in emerging markets. Moreover, quality companies tend to be market share gainers within these secular tailwinds – which turbocharges their growth.
For example, China’s rising middle class has been a boon for western luxury and apparel brands. Thanks to the globalisation of travel and media, all corners of the world know premium brands like Estee Lauder, Louis Vuitton, and Nike. They therefore transition relatively easily into these new, high-growth markets.
One final point about the role of growth in the compounding cycle. It is preferable for a company to fund growth with cash from internal operations. Doing so, reduces the need to finance it with risky debt or dilutive equity issuance. Both can be value destructive for existing shareholders. Cash conversion – free cash flow as a percentage of earnings – is therefore something quality investors pay close attention to.
The Compounding Cycle
Persistence of the compounding cycle relies on new sources of high-return growth opportunities to deploy capital towards. In the absence of growth opportunities, shareholder distributions (dividends/buybacks) create more shareholder value.
Relationship Between Growth, Returns and Capital Allocation
The following formula can also help us visualise the compounding cycle. It specifically uses ROE, but any return on capital metric carries the same logic.
g stands for the sustainable growth rate of earnings. ROE stands for return on equity. And the retention rate is the percentage of earnings not paid out as dividends. In other words, the retained earnings reinvested back into the business. Retention rate is otherwise known as the plow-back ratio, or (1 – payout ratio) = 1 – Div/EPS.
You should be able to see how this relates to the diagram above. Management decides what percentage of earnings to distribute to shareholders and what percentage to reinvest. This in turn is a function of the growth opportunities available to the company. If there are plentiful sources of growth opportunities, then it makes sense for management to retain more of its earnings. If the retained earnings are deployed towards high returning investments, then this will drive growth going forwards.
There is one note of caution, however. Whatever return metric you’re looking at, whether that’s ROE, ROIC, ROCE etc., it is important to remember that they are lagging indicators of capital efficiency.
That is, they reflect historical investments that are only now bearing fruit as current earnings. They won’t reflect more recent investments, as there is usually a lead time before any investment shows up in earnings.
Therefore, investors need to constantly monitor capital allocation decisions. Quality investing is just as much about assessing management’s ability to deploy cash, as it is about analysing a company’s fundamentals.
Having said that, a company with a long track-record of high returns on capital is a good starting point.
Examples of Quality Companies
Examples of quality companies include L’Oréal, Unilever, Novo Nordisk, Microsoft, and Nike to name just a few.
Each have consistently found new ways to deploy cash into high-return growth opportunities. In doing so, they have carved out exclusive franchises in the process – ones that are extremely difficult to compete with and disrupt.
Unilever
Unilever’s historical marketing investments into the Dove soap brand have been investments, in effect, into the consumer’s consciousness – creating a mental barrier to entry for any rivals. This has allowed them to grow, and maintain, a dominant market share.
L’Oréal
L’Oréal has invested heavily in both R&D as well as marketing and promotion, and has acquired a number of new brands; the returns of which have been attractive. Excess capital has been diverted into paying a steadily increasing dividend and reducing its shares outstanding by more than 10% through buybacks.
Novo Nordisk
Novo Nordisk is the global leader in diabetes treatments, with a 50% share of the global insulin market. Incidences of diabetes have grown dramatically in recent decades due to rising obesity rates.
Whilst this has provided a tailwind to sales, the true value behind the company stems from its numerous R&D breakthroughs in finding more effective and easier delivery methods of insulin (e.g., self-dosing pens).
Relentless innovation has been maximised through its efficient manufacturing capacity and a global sales footprint, which has created economies of scale. Such competitive advantages have led to a 70% ROIC, 40% operating margins, and a 20% earnings CAGR over the last decade.
Quality Investing in Market Leaders
Quality businesses may not always make the front pages, or be involved in the latest hot trend, but their impenetrable moats mean that they consistently deliver for their shareholders – in good times and bad.
This consistent execution often leads them to becoming market leaders in their respective industries and allows them to stand the test of time. For example, the average age of a company in the Fundsmith Equity Fund is 96 years old. This means they have survived wars, financial crises, and all sorts of market cycles – coming out stronger than ever on the other side.
Characteristics of Quality Companies
Whilst quality companies come in all different shapes and sizes, there are a few common traits that can help us identify them.
1) Pricing Power
Companies able to increase prices without corresponding increases in cost or significant reduction in sales volumes have substantial pricing power. Pricing power exists when consumers are insensitive to price increases, which is a function of having a strong competitive advantage. Pricing power is key to maintaining high margins and returns on capital.
2) Market Share Growth
A company with better products and superior execution should regularly attract new customers from competitors and increase market share. Market share growth can be isolated from overall market growth and hence is less dependent on macroeconomic variables. It also reinforces competitive advantages based on scale e.g., negotiating better terms with suppliers and distributors.
3) Brand Strength
Strong brands offer something differentiated and create an affinity with their customers. Differentiation and attachment allow for premium pricing and gains in market share. The link between pricing power, market share and brand strength are strong.
4) Recurring Revenue
Recurring revenues arise when an existing customer base buys additional services or products from a company. A software company collecting regular subscription fees is an example of recurring revenue. Recurring revenues increase the predictability of cash flows.
5) Economies of Scale
A business with economies of scale will see its average costs fall as sales increase. The most scalable businesses tend to have asset-light business models, which means that the cost of acquiring new sales is relatively low. This creates operating leverage and high asset turnover, which in turn leads to higher margins and returns on capital as a company grows.
6) Technology Advantage
A product offering superior benefits for customers will have a competitive advantage and should yield above-average economic returns. The caveat is that this technological advantage needs to be sustained over time in order to fend off competitors.
Quality Investing is About Finding “Compounders”
Financial theory assumes that abnormal performance is unsustainable, and that outsized growth, profits, margins, or returns are destined to return to the average as new competitors enter the space.
Whilst that is true for most companies, those exhibiting the aforementioned patterns of ‘quality’ – whether that is pricing power, brand strength, recurring revenue, etc. – tend to overcome these forces of mean-reversion and compound at above-market (excess) returns for long periods of time.
For this reason, quality companies are often referred to as ‘compounders’ and exhibit price charts that go bottom-left to top-right over the long-term. They largely evade the cyclical ebbs and flows that plague lower-quality companies, and provide more consistent returns.
How to Screen for Quality Stocks
Before getting into the specifics of quality screening, you may find it helpful to brush up on how to use a stock screener.
So how can we screen for quality stocks in practice? Whilst there are a lot of nuances and qualitative factors to consider (as alluded to above), fortunately there are also some quantitative metrics that help identify companies with quality characteristics.
Margins
Margins are a measure of pricing power, profitability, and competitiveness. Since high quality stocks excel in all these areas, we can identify them by screening for stocks with high margins.
This begs the question as to what is meant by high margins.
This will vary from industry-to-industry, as some industries are more competitive and capital intensive than others.
If you want to avoid these lower quality industries, then you can just screen for companies with the highest margins in a stock universe. For example, you could screen for the 10% of companies with the highest margins in the S&P 500.
Alternatively, you could set a minimum threshold that you want companies to meet. For example, you could screen for companies with operating margins of at least 30%, which is respectable for any industry.
If you are agnostic to which sector a stock comes from, then you can screen for companies with higher margins than their sector average.
Sustained margin expansion also signals strength. Therefore, a third way to find quality companies is to screen for those with expanding margins in recent years.
Read this article to see different profit margin stock screener settings.
Return on Capital
Return on capital metrics measure the effectiveness of a company’s capital allocation decisions. In addition, they are arguably the best shorthand expression of its industrial positioning and competitive advantages.
A quality business allocates capital efficiently and has strong competitive advantages, which means it should rank highly on return metrics.
As with margins, there are generally three approaches you can take when screening on return metrics:
- Screen for companies with the highest absolute returns in a stock universe
- Screen for companies with the highest returns relative to their industry peers
- Or, screen for companies whose returns have been growing in recent years
For a more detailed explanation, read this article on ROE, ROIC & ROCE stock screener criteria.
Summary
- Quality investing is an investment style seeking to buy the best companies.
- A quality company is one that has a competitive advantage, or economic moat, that makes it hard to compete with.
- Strong and stable free cash flow growth is a hallmark of a quality company.
- Compounding at high returns on capital help them achieve this.