June 28, 2016

Quality investing: What you need to know

The concept of assessing a company’s quality gained popularity after the collapse of the tech bubble of 2001. Here we explore the quantitative and qualitative measures implemented to determine quality investments.

Many investors are familiar with the concept of buying shares based on either valuation criteria (value investing) or potential earnings growth (growth investing). Another style of investing, where shares are bought based on the “quality” of the company, is quality investing.

Origins of quality investing

The concept of assessing a company’s quality gained popularity after the collapse of the tech bubble of 2001 when investors discovered that companies such as Enron, Worldcom and Parmalat, which appeared to offer strong growth or a cheap valuation, had actually manipulated earnings and balance sheets and committed other forms of financial fraud.

Quality assessments have also been applied to other asset classes such as commercial real estate (for example A grade versus B grade office space) and to bonds by credit rating agencies (for example investment grade versus “junk” or speculative grade bonds).

Like value investors that focus on a company’s price to earnings ratio, its dividend yield and its price to book ratio, quality investors have a range of criteria that they believe influences or explains a company’s business success. Quality criteria include both quantitative and more subjective qualitative factors.

Financial metrics to determine quality

Quantitative or financial metrics that seek to measure a company’s quality include earnings measures such as a company’s return on equity and return on invested capital (i.e. debt plus equity), the size of its profit margins as well as the quality of its earnings (see chart below with an example of an earnings quality score for Telstra). Balance sheet measures may also be assessed such as debt to equity ratios as well as the level of accrued income and expenses which may be subject to accounting manipulation.

Qualitative factors to determine quality

Qualitative factors used by quality investors include assessments of the company’s management team including the level of senior management turnover, the transparency, timing and level of information the company discloses to investors and whether the management has a history of delivering on prior promises.

The strength of the company’s business model, including the degree to which the company is focused on its core business, whether the core business has an “economic moat” or sustainable competitive advantage that helps protect profit margins from competition, is another qualitative criteria to assess quality. The degree to which revenues are diversified geographically and by customer may also be taken into account in assessing the quality of the business model.

Seeking quality companies at attractive valuations

Quality investors may assign scores to the different factors such as the strength of the management team, the health of the balance sheet, the soundness of the business model and then invest in the companies with the best overall score.

Alternatively, investors may also seek to combine quality factors with valuation or growth criteria in order to invest in the cheapest high quality companies or the best quality companies with the highest growth potential. By seeking quality companies at attractive valuations investors aim to avoid “value traps” or companies that are cheap for a reason as well as avoiding low quality high growth companies such as those companies that disappeared following the 2001 tech wreck.