Gauging quality companies

It’s difficult to reliably determine whether a given security has been issued by a truly quality company and to accurately establish its intrinsic value, but doing so is a critical way to add value to the investment process.

Proper portfolio construction, diligent risk management, efficient trading, effective administration and responsive client service are all vitally important aspects of our business. But although many managers look at similar features to distinguish a high-quality company, quantitative measurements (financial metrics, capital allocation) and qualitative characteristics (a company’s business model, its management) can vary.

Financial metrics

An investment decision shouldn’t be based solely on positive financial metrics, but unexplainable negative findings in key areas shouldn’t be ignored when determining the quality of a company.

Moreover, any signs of deterioration in key areas of investments already held should trigger a thorough review and further action if they impact the original rationale for holding a security.

Having a strong balance sheet, especially compared to industry peers, is a primary prerequisite in considering a company a quality investment. It enables a company to function effectively, regardless of credit environment. Little or no debt on balance sheets is preferable, but higher financial-leverage ratios may be acceptable, depending on the industry and the specific investment strategy, in firms with strong market positions and highly visible revenues.

Cash is both a critical resource to companies and a significant indicator of performance that isn’t easily manipulated for the benefit of appearances, so it would be difficult to overstate its role in fundamental analysis. At their most basic level, quality companies are effectively cash-generation machines, so any problems in their cash flows are significant red flags. Advisors should look for companies with abundant cash flows that have sustained (and can continue to sustain) growth rates over long terms. This helps minimize the risk of chasing after momentum-driven stocks.

Both top- and bottom-line data will factor into an analysis. Ordinarily, a company should deliver highly predictable and consistent earnings. Seek out companies with recurring or low-volatility revenues and long product cycles that aren’t dependent on closing large amounts of business in a short period of time to deliver consistent earnings. Vital revenue streams and cost drivers should be apparent, and related margin implications should be clear.

Also, companies with visible means of improving their margin structure and returns over time are desirable. Growth-oriented models will tend to favour superior revenue growth, accelerating earnings growth and potential for upside earnings surprises, while value-oriented models will be more concerned with normalized earnings power and its relation to price.

Return on invested capital (ROIC) measures the cash rate of return on capital that a company has invested, and is widely considered to be a reliable metric for distinguishing quality companies. But it’s often overlooked because it’s not as readily available as the more commonly used financial ratios. In most instances, a quality company will consistently maintain an ROIC in excess of its weighted average cost of capital, and should produce a rising ROIC over time.

Measuring the net income a company produces from its total shareholder equity or book value, return on equity (ROE) is another quantitative indicator that allows for a range of acceptable values based on a number of circumstances. A quality company should generate an industry-leading and steadily rising ROE as confirmation of increasing efficiency in the use of equity to generate profits.

Businesses allocate resources to generate returns for shareholders, and a quality company will consistently manage this process with great efficiency, no matter the stage of its life cycle. An advisor should understand a firm’s capital structure and see sufficient evidence of its capital-allocation discipline before investing. Though expectations for performance will vary depending on size, key criteria should include:

Dividends and share repurchase: Companies large and mature enough to generate sufficient free cash flow should be paying out appropriate dividends. Monitor dividend history and look for increasing yield and growth or, at a minimum, dividend growth potential. Share repurchase programs usually indicate quality companies, provided there’s confidence in management, supported by qualitative and quantitative indicators. Intelligent M&A: In short, no empire builders need apply. Look for companies that pursue strategic, goal-oriented M&A activity that can be expected to contribute to earnings rapidly and for the foreseeable future. The potential downsides to proposed M&A activity should be clearly understood.

Prudent capital expenditures: The key to successful investing and wealth creation is deploying capital at returns that exceed its cost. While growing firms may require significant capital investment, expenditures that are high relative to historical patterns or depreciation are usually a red flag. Firms and management teams with a history of capital destruction should be avoided.

Qualitative characteristics

While qualitative traits are often more difficult to discern than quantitative ones, they represent a good way to gain an information advantage. As with quantitative measures of quality, different traits will apply to companies in different market capitalization ranges and stages of their life cycle.

In mature markets, seek out industry leaders. They should have the best-in-class product or service and leadership positions in both developed and expanding markets. Dominant companies often have pricing power and near-monopolistic profits.

Large or small, young or old, quality companies should take increasing market share from their competitors over time. If that’s not the case, even when earnings or revenues are increasing, there may be a fundamental problem with the company or its product or service that will only be clear in hindsight. Also, companies operating in growing or expanding industries are better than those in shrinking markets.

Wide economic moats represent large and sustainable competitive advantages. They act as barriers to entry against other companies, and vary among industries. Examples include exclusive patents in technology or healthcare sectors, large economies of scale in manufacturing or industrial sectors, and cost advantages in consumer sectors. However, they’re characterized more by their effect on competitors than by their form, which can make them difficult to recognize.

Among younger or smaller companies, innovation and efficient R&D spending are key considerations, as they can provide greater control over pricing of products or services. Companies with disruptive technologies can displace or undercut existing market leaders and enable significant market share gains, and so should also be favoured.

To make sound judgments about the quality of a company, advisors should have a solid grasp of its business ecosystem – its competitive landscape, its competitors, the industry’s benchmarks, the cyclicality or secular growth patterns of its business, etc. Proven business models with several full business cycles of operation are thus better than untested models.

There’ll always be products people are compelled to use because of their unique and vital functions. Novel treatments for life-threatening or debilitating illnesses are a prime example. Sometimes these products are mandated by law and sometimes they’re monopolistic products with no viable alternatives, such as patented technologies.

A metric that allows for further insight into a company, its competitors, suppliers, customers, industries and the economy at large is an in-person meeting with company management. Much has been written about business management, but principal things to watch for include:

Seasoned teams: There’s no substitute for first-hand experience in business management. Look for leaders with established track records of performance in the industry and several business cycles’ worth of experience. Even a merely adequate manager may guide a company to positive results in good economic circumstances, so look for managers with a proven ability to steer companies through difficult straits with proficiency, preferably more than once.

Stable teams with depth: Look for low turnover and teams that have been in place long enough to rightfully lay claim to a company’s present successes or give meaningful insights into its past failings. Also look for a succession plan: are successors working with current management, learning from predecessors directly and establishing validity with their own companies, shareholders and the market?

Shareholder-oriented managers: Look for managers who clearly understand and whose actions confirm their primary role as custodians of shareholder value. Also look for appropriate compensation structures that align managers’ interests with those of the shareholder, and reward the steady increase of shareholder value. A meaningful portion of management compensation in the form of equity – their “own skin in the game” – is a positive indicator.

Visionary management: Managers should offer clearly defined long-term strategies to increase shareholder value and practical paths to success. They should have both near-term and long-term plans that are integrated into a cohesive vision of their company’s future.

The stock-selection process is not black-and-white, and there’ll always be exceptions to the rule. But using various quantitative and qualitative metrics to devise a selection strategy will help an advisor determine more accurately the best of the best.

---

Jeffrey Russell, CFA, is Managing Director, Senior Portfolio Manager and Robert Swab is Managing Director, Portfolio Manager, Senior Client Portfolio Manager at ClearBridge Advisors, LLC.ClearBridge Advisors, LLC is a wholly owned, independently managed subsidiary of Legg Mason, Inc.

---

Jeffrey Russell and Robert Swab