After nearly two decades of investing, one thing gives me confidence in my shareholdings more than anything else.
That one thing is ‘quality’.
If the firms behind my shares operate good quality businesses, that characteristic will likely shine through in the end to ensure a successful investing outcome.
Quality first
I rate quality above price and momentum, and look for it first.
When searching for new investments, I reduce my universe of possibilities to firms with good quality businesses, and only then look for a share price that values that business as cheaply as possible. Quality plus a reasonable buying price equals good value, which is essential in an investment, I reckon. If the shares have momentum and are trending up, that’s the icing on the cake.
Quality is desirable, which means the firm is attractive to other investors and other businesses and they want to buy.
Quality has resilience, which means the firm tends to recover more readily from temporary setbacks.
Quality has form, which means the firm trades well and business tends to grow.
All these things work to keep shares in quality businesses moving up, and I see ‘quality’ as both insurance against the downside and a driver towards the upside.
To me, quality is the supreme characteristic to look for in shares, but how do you find it?
In search of quality
One way is to look at the numbers.
Quality businesses tend to have a record of consistent net cash from operations. The net cash inflow figures on the cash flow statement should average out close to figures for pre-tax profit on the income statement. That shows that paper profits are backed up with real cash profits, and it’s a sign that the firm operates a good business.
In strong businesses, profit margins tend to be higher than in other, weaker businesses. Divide either gross or net profit by sales to work out a percentage for margin and compare it to other firm’s margins.
Return on capital employed (ROCE) is also a useful and one of the main financial measures to determine how well a company is performing. Divide operating profit from the income statement by total equity minus current liabilities, which are both from the balance sheet — the higher the ROCE the better.
A strong trading niche
To earn high showings in these measures firms with quality businesses often operate in a trading niche that gives them the power to set selling prices at an economically viable level. I like to think about that and how well-defended and sustainable such a niche might be.
For example, many cyclical businesses deal in goods and services that consumers find easy to forego when times are hard. Revenues and profits tend to wax and wane with the undulations of the wider macroeconomic cycle. Cyclical businesses have their place in an investment portfolio but timing is important because these firms tend to lack the attributes of quality that I’m looking for in a longer-term investment, and their share prices can be volatile.
Defensive businesses are at the other end of the scale and are often firms with businesses dealing in consumer goods with a short life, so customers come back time and again to re-buy. Such firms tend to defend their trading niches with strong brands, patents, geographical and cost advantages, as well as in other ways.