For anyone new to stock picking and unfamiliar with its jargon, the idea that “quality” investing is a discipline unto itself must be disconcerting. Why, really, would you choose anything else?
Both the confusion and the answer lie in how “quality” is defined. Almost all publicly traded companies can, in some sense, be considered competitive at what they do, and most manage to profitably sell products that customers want.
Intuitively, the ability to earn money could be a marker of quality in and of itself. Cash is cash, after all. But it is the nature of this profit making that investors tend to focus on when they speak of “quality investing.” And while it’s subjective, ‘quality’ tends to refer to steady, growing cash flows, backed by strong, high margins and businesses with strong competitive positions.
Sometimes these qualities are most apparent when sectors are compared side by side.
Airline operators, for example, face stiff price competition for the seats they sell, but have little control and oversight of their main source of operating costs, consumer confidence, or long-term capital expenditures. In general, that makes them more susceptible to economic cycles than a sector like software development, where the upfront costs required to carve out a niche and sought-after product can pave the way for years of customer demand and reliable operating gear.
It must be said that not all airlines or software companies are the same. What makes a company ‘quality’ often depends on whether the products in its market are commoditized and on its level of specialization within that market. Although there are many chip manufacturers around the world, Taiwan Semiconductor Manufacturing Company (US: TSM) it is widely recognized as the most advanced. Although thousands of its competitors try, only one beverage company has the combination of branding and distribution power of Coca-Cola (USA: KO).
Together, consistency and high margins are a recipe for the kind of cash generation that enables companies to reward shareholders and grow. For this reason, ‘quality’ stocks tend to have higher valuations, reflecting expectations that they will outperform lower quality stocks over time. Of course, that means using smart due diligence tools and endpoints to identify them.
That’s easier said than done at best. But in the past year, as investor risk aversion has risen steadily, hallmarks of quality such as growing free cash flow and strong, stable margins have not stopped stock prices from falling. otherwise excellent companies.
For proof, look no further than our high-quality, large-cap display, one of the most successful automated strategies we’ve run on these pages over the last decade. Between December 29 and June 16, display suffered a 28% drop on a total return basis, a drop slightly worse than display’s decline in the first half of 2020.
|Name||ITDM||Total Return (Sep 14, 2021 – Sep 6, 2022)|
|FTSE all shared||–||two%|
|High quality large caps||–||-eleven%|
|Source: Refinitiv Eikon Datastream|
If it weren’t for the 25 percent total return aided by the acquisition of last year’s top-performing pick, the cybersecurity team Avast (AVST), the display would likely have underperformed the FTSE All-Share by more than 13 percent. But in most cases, the decline in share prices was not reflected in a collapse of margins. In fact, operating margins across the 11 selections on the 2021 screen actually improved by an average of 2.6 percentage points, while sales expanded by a fifth compared to some admittedly Covid-hit figures from 2020/ twenty-one.
|Company||One year sales change||Ebit margin (1 year)||Ebit Margin||Change of margin (pctg)|
Given the circumstances, last year’s drop is arguably better than it could have been, even if it’s the first time the screen has posted a negative annual return in its history. Certainly, investors will have factored in higher discount rates in their future cash flow forecasts, as well as a degree of demand destruction in the coming years.
But the hesitant rally in quality stocks from June lows (more than triple the benchmark’s rise over the same period) suggests there are buyers ready to swallow short-term uncertainty for the opportunity to acquire good companies at a lower price. price hit.
Whether or not those prices could take a further beating remains to be seen, but the track record of our high-quality large-cap screen shows why long-term investors may feel bullish. Since we started using the screen in 2011, it has returned 450% on a total return basis, compared to 126% for the FTSE All-Share. Even factoring in last year’s slump, that translates to a 17 percent compound annual growth rate, more than double the benchmark’s 7.5 percent and on par with the best-performing funds over the same. period.
The stock screens on these pages are intended as a heads up for further investigation rather than out of the box portfolios, but if we factor in a 1.25 percent annual fee to account for real life trading costs , the screen’s overall performance would drop to a still respectable 380 percent in 11 years.
Our large-cap version of the high-end display is interested in many of the same qualities as its smaller counterpart, which we last ran last month. These include positive free cash flow, anticipated earnings growth, a track record of expanding margins, improved returns on principal, and manageable interest payments.
Where it differs is in its approach to value criteria. Instead of seeking to balance quality with relative low cost, the large-cap screen now takes a much more ambivalent view of a stock’s valuation, focusing instead on companies with the best returns on capital and profit margins. his class.
Last year, these criteria were watered down to get around some of the problems created by the big hit many companies took from the pandemic and cast the net on the FTSE All-Share, from which the results are drawn. This year, I’ve reverted to the previous tests for top quartile returns on equity and operating margins, but require only that companies show relative (rather than consecutive) growth in each of these measures over three years. The tests are as follows:
■ Return on equity (RoE) in the highest quarter of all stocks evaluated in each of the last three years.
■ Operating margin in the highest quarter of all stocks evaluated in each of the last three years.
■ Earnings growth forecast for each of the next two years.
■ Interest coverage of five times or more.
■ Positive free cash flow.
■ Market capitalization greater than 1,000 million pounds sterling.
■ RoE growth in the last three years.
■ Operating margin growth in the last three years.
■ Growth in operating income in the last three years.
This year, seven stocks passed all tests. Because our quality tests are independent of stock price, it stands to reason that five of them also made the 2021 list, despite the lower-quality market performance of last year’s selections. In fact, three of this year’s companies, RELX (REL), Moneysupermarket.com (MONY) Y Experian (EXPN) – also passed all the criteria set in 2020, while RELX also made the cut in 2019.
There is something reassuring about this feature of the screen, as the investment case for quality stocks is best presented as part of a buy-and-hold strategy. In fact, the Geico screen we featured last week, which looks for international stocks with a long-term track record of consistently strong returns on equity, has a similar philosophy. The Guinness Global Equity Income Fund, on whose methodology that screen is loosely based, prefers to hold shares for a minimum of three years.
This is logical, considering that strong economic moats and returns on capital are not always reflected in short-term stock price performance. Over time, however, such advantages tend to reveal themselves and reward investors in the process.
|Name||ITDM||market cap||Cash/net debt (-)*||Price||Fwd PE (+12 months)||FORWARD DY (+12 months)||Annual FCF (+12 months)||PLUG||Net debt/Ebitda||Operating cash/Ebitda||EBIT margin||TOUCH||5-year sales CAGR||5-Year EPS CAGR||Fwd EPS grth NTM||Fwd EPS Grth STM||mom of 3 months||12 month old mom||% change in EPS ahead of 3 months||% change in EPS ahead of 12 months|
|auto trader||AUTO||£6,064 million||£42 million||644p||23||1.4%||4.4%||4.6||–||111%||69.5%||61.6%||6.8%||10.4%||6%||9%||11.7%||0.6%||-0.2%||12.9%|
|avast||AVST||£7.536 million||-535 million pounds sterling||721p||23||1.8%||–||4.5||0.9x||144%||39.7%||18.1%||22.1%||66.6%||6%||3%||52.1%||21.7%||12.1%||12.0%|
|Dr Martens||DOCUMENTS||£2.419 million||-166 million pounds sterling||242p||12||2.6%||6.3%||1.5||0.6x||68%||25.6%||37.6%||–||–||9%||13%||-10.1%||-42.6%||4.6%||19.5%|
|experience||SPENT||£24.139 million||-2.97 billion pounds sterling||2,621p||twenty-one||2.0%||4.4%||2.1||1.9x||96%||23.2%||18.5%||6.7%||5.7%||14%||eleven%||2.1%||-20.4%||9.7%||32.3%|
|GSK||GSK||£54.682 million||-15,579 million pounds sterling||1,344p||10||4.2%||10.6%||0.8||2.0x||82%||22.2%||18.3%||4.1%||36.1%||10%||9%||-37.5%||-26.9%||6.1%||23.1%|
|Moneysupermarket.com||MONEY||£1,037 million||-56 million pounds sterling||193p||13||6.3%||8.1%||1.2||0.8x||80%||23.2%||28.8%||0.0%||-6.2%||14%||fifteen%||5.4%||-23.8%||5.8%||-1.3%|
|RELX||NIR||£43.373 million||-6,797 million pounds sterling||2,260p||twenty-one||2.5%||4.5%||2.2||2.4x||96%||26.4%||19.7%||1.0%||6.3%||12%||9%||1.7%||2.5%||3.5%||13.6%|
|source: FactSet. *FX converted to £. NTM = next twelve months; STM = second twelve months (ie within a year)|