A lot has been written on growth investing and value investing, yet little has been said about the most popular investment strategy today. Quality investing, or growth at a reasonable price (GARP investing), is by far the most popular investment style employed by institutional portfolio managers.
Today, let’s take a look at what is quality investing, and how you can use this style to find quality investments.
What is quality investing?
Quality investing is about focusing on the company with consistent and sustainable growth. These are businesses with the potential to generate stable, consistent returns and offer potential capital protection.
This involves investing in high-quality companies that can consistently compound shareholder wealth at a superior rate over the long-term while offering relative downside protection.
It’s about finding companies with high-quality franchise businesses, ideally with recurring revenues, built on dominant and durable intangible assets, which possess pricing power and low capital intensity.
When evaluating these companies, focus on:
- Franchise quality and durability
- Financial strength
- Industry position
- Management quality
Quality investments are equity compounders
The goal of quality investing is to find “equity compounders”. These are companies that have been able to consistently compound shareholder wealth at superior rates of return over the long term.
Few companies can achieve this level of performance. In our experience, most companies are erratic or inferior creators of long-term wealth.
Equity compounders with strong franchise quality have a sustainable competitive advantage by virtue of their intangible assets, which competitors generally have difficulty re-creating or duplicating.
These dominant and durable intangible assets include strong brand recognition, which tends to be driven by:
- Customer loyalty
- Distribution networks
In contrast, dominant assets that are physical are more easily replicated and often lead to price competition and erosion of a company’s return on capital.
Quality investing vs. value investing
There is a strong relationship between quality investing and value investing. The two are philosophically similar.
Quality investing can even be viewed as modern value investing, which is to buy high-quality investments without paying premium prices.
Warren Buffett, the icon of value investing, is actually a quality investor at heart. His mantra is that:
“It’s far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.”
Berkshire Hathaway’s success can largely be explained by his commitment to buying high-quality investments.
Characteristics of quality investments
What is a methodical way to approach quality investing? The key financial characteristic of equity compounders is that they enjoy sustainable, high return on invested capital (ROIC).
High ROIC is generated by a combination of recurring revenues, high gross margins, and low-capital intensity.
This combination helps support strong free cash flow generation that must be either reinvested or distributed to shareholders. Any M&A activity should be fully justifiable on ROIC basis rather than “strategic” or “accretive” grounds at the expense of eroding overall ROIC.
The financial strength of these equity compounders tends to come from the innovation-driven intangible assets that the companies possess, which, in turn, provide pricing power.
GARP investing also tend to be relatively robust in economic downturns, because there is a market flight to safety. Quality investments with steady operational cash flows and no burdensome debt leverage are favored in a recession. Their profits are typically less sensitive to economic conditions given repeat purchases at high growth margins.
This, combined with the low cyclicality of top-line demand (due to secular growth of demand and strong brand loyalty), help insulate compounders from the negative cyclical impacts on operational cash flow.
These characteristics, coupled with modest top-line growth, have helped ensure that the intrinsic value of compounders grows over time.
High ROIC is generated by a combination of recurring revenues, high gross margins, and low-capital intensity.
Companies with a high ROIC have outperformed over time
Quality investing process
We just talked about ROIC. Finding investments with consistently high ROIC is the most important factor in quality investing.
Joel Greenblatt’s “Little Book that Beats the Market” has been equally influential in getting investors to pay attention to quality. The logic of Greenblatt’s “magic formula investing” is clearly that of combining quality and value.
The magic formula is about ranking firms on the basis of return on invested capital (ROIC) and earnings yield (defined as EBIT-to-enterprise value), respectively. It’s about only buying stocks with the highest combined ranks.
ROIC serves as the measure of quality, and earnings yield serves as the measure of value. The formula is explicitly intended to ensure that investors are “buying good companies. . . only at bargain prices.”
How to calculate ROIC to find quality investments
Simply put, Return on Invested Capital (ROIC) measures the return on the total capital invested in the business.
To calculate ROIC, look to the company’s financial statements, which are found on SEC Edgar. ROIC is defined as:
ROIC = NOPAT / Total Operating Capital
On the income statement, look for Earnings Before Interest and Taxes (EBIT). Multiple EBIT by (1-tax rate) to arrive at Net Operating Profit after Taxes, or NOPAT.
NOPAT = EBIT*(1 – tax rate)
We have the numerator, now we look for the denominator, Total Operating Capital. We look at the balance sheet for this information.
Total Operating Capital consists of notes payable, long-term bonds, preferred stock, and common equity.
Note that it does not include cash. Every business needs a small amount of operating cash, but most cash on the balance sheet for a healthy business can be considered excess cash. Excess cash does not generate business value, thus is excluded from Total Operating Capital.
Total Operating Capital = Average Debt Liabilities + Average Stockholder’s Equity
Quality investing considerations
The advantage of ROIC is that we are considering the total return on the total invested capital, regardless of the company’s capital structure.
In particular, we look for companies with increasing ROIC over time.
Here are 5 considerations that drive high and increasing ROIC.
#1: Market cap
In quality investing, the relative strength of a company within its industry is more important than the market cap. In terms of industry structure, quality investments enjoy a high relative market share in monopolistic or oligopolistic markets.
These companies generally enjoy high barriers to entry, usually as a result of the intangible assets they possess and their ability to continually innovate. Such an industry position provides a company with strong pricing power and organic growth potential.
The quality of growth remains a crucial consideration. Quality sustainable growth is preferred in both the short-term, which boost earnings per share (EPS), and also the long-term, driven by a high ROIC.
We prefer to own a high-quality global franchise business that sells to the emerging market consumer rather than own a potentially lesser quality company listed in the emerging markets.
Another characteristic of quality investing relates to the quality and focus of its management. It is crucial to invest in companies whose management has demonstrated a history of disciplined and efficient use of free cash flow.
When evaluating the quality of a management team, we seek evidence of disciplined capital allocation and distribution practices.
#5: Franchise value
It is vital for management to not be distracted from the long-term task of building and improving the company’s intrinsic value by the temptation to meet short-term targets. Cuts to advertising and promotion spending, or research and development budgets can have devastating long-term consequences to brand strength and recognition.
As a result, quality investing is about favoring companies whose employee compensation and marketing strategies foster the compounding that is in shareholders’ long-term interests.
Avoid these quality investing traps
Now that we’ve talked about what to look for in quality investments, let’s go over what to avoid in GARP investing.
You’ve heard of value traps. Now let’s talk about quality traps.
Avoid fading companies
When searching for quality investments, avoid traps in the form of fading companies.
By fading companies, we mean those where patents or licenses are soon to expire, where new technology or a change in fashion or new regulation can disrupt a franchise. Companies that are overly dependent on a single brand or product are more vulnerable to disruption.
Avoid greedy management
Poor or greedy management is also a risk. A franchise can be eroded by management that cuts advertising and promotion spending or research and development activities to meet short-term earnings targets, that sets poor pricing policies, or is not disciplined in its capital allocation.
Avoid acquisitive companies
Acquisitions may be especially damaging for quality investments. For example, a company generating a 30% ROIC may damage its long-term compounding potential if it acquires a company in a deal that generates 5% to 10% ROIC in an effort to boost EPS. Accretion of EPS does not necessarily equate to value creation and instead can result in significant value destruction, even if the target company is itself a compounder.
Where to look for quality investments
As previously mentioned, our experience is that it is not easy to find compounders with strong franchise quality and financial strength in many sectors of the market.
Avoid capital-intensive sectors
Strong resilient franchises are rare in capital-intensive industries such as telecommunications, utilities, oil and gas exploration and production, commodities, chemicals, and transportation. Capital intensive or strongly cyclical business do not ordinarily generate sustainable returns that outperform the market. They have weak pricing power in the case of many commodity producers.
Likewise, we have found that financial service and transportation companies commonly earn low returns on an unlevered basis. Growth businesses are vulnerable to rapid product or patent obsolescence. These issues seldom generate the repeat consumer business that is vital to generating long-term wealth.
Focus on capital-light, brand-heavy industries
Instead, quality investments are most likely to be found in industries where relatively capital-light innovation can create new demand and help support pricing power.
Over the last 10 years, strong equity performance has been associated with those companies exhibiting pricing power.
In this regard, business-to-consumer industries are best. While there are some franchise companies in the pharmaceutical, media/publishing, and IT sectors, strongest franchise stocks are typically companies producing branded consumer goods.
While these are commonly found in consumer staples, it’s important to stress that not all compounders are found in this sector. Conversely, many consumer staples companies that are not compounders.
Examples of top quality investments
In quality investing, we avoid industries that are capital intensive with weak pricing power and look for companies that are capital-light and consumer-facing businesses, with strong brand loyalty and high pricing power. Quantitatively, they should generate high ROIC.
Here are some of the most well-known quality investments today and their ROIC:
This is a good list for you to start doing research on for your own portfolio.
Quality invest: final words
Quality investing is modern value investing. It’s about finding companies that generate high ROIC and paying a reasonable price for them.
Focus on company fundamentals when doing your research on company quality and valuation. Find franchise stocks, given their quality, remain attractively priced relative to their long-term intrinsic value and relative to the broad market. Seek out high-quality businesses built on recurring revenues, high gross margins, and low capital intensity, with the potential to help preserve capital in down markets. The reasonable price depends on doing your own DCF valuation and arriving at your own conclusion about the fair price.
That’s it! Good luck and happy investing. Leave any comments below.