Fund managers often like to say that they invest in high quality companies.
At first glance, it appears they are stating the obvious. Who would want to invest in anything other than a quality company? Quality can be a generic term meaning something that is great or valuable, but in investment circles it has a more specific meaning. For a company to be classified as quality, it has to meet certain criteria. Whilst there is no fixed definition as to what those criteria are, there is broad agreement as to the attributes of a quality company.
Developing the concept of Quality investing
Quality as an investing concept can be traced back to Benjamin Graham and his 1949 book The Intelligent Investor. The concept grew in popularity around the early 2000s following the bursting of the dot com bubble and other spectacular failures like Enron and WorldCom.
Jeremy Grantham of asset management firm GMO is a strong proponent of quality investing. He focuses on the attributes of high return, stable return and low debt. These attributes of profitability, earnings stability and capital structure have become the basis of many quality investing strategies. (Novy-Marx, 2014)
A study by Frazzini, Kabiller and Pedersen (2012) found Warren Buffett’s focus on buying high quality stocks, largely explains the performance of the listed stock portfolio held by Berkshire Hathaway, Buffett’s primary investment vehicle. (Novy-Marx, 2014)
Stocks are selected as high or low quality based on an analysis of their financial statements which measure the performance of the business. Ratios are used in the majority of cases to allow comparison across companies.
As most of these measures are based on accounting definitions, there is the possibility that the figures could be manipulated. However this should only be an issue at the margin. The accounting quality attribute, described below, attempts to overcome this.
When looking broadly at the concept of a quality company it can be thought of in a number of different dimensions:
- Is it a good company (quality of the franchise)
- Is it an improving company (Fundamental momentum)
- Is it a safe company (Bankruptcy & earnings risk)
The quality of the franchise is looking at whether the business is strong and stable. It looks at measures like profitability, cash generation, stability and growth of revenue, earnings and margins. Benjamin Graham is best known as…
