In the last decade quality has become something of a buzz word in investing.
I suspect that no right-minded investment manager would set out their stall based on saying they look for poor quality businesses. Hence just talking about quality, without giving more detail, risks being vacuous.
With a background in quantitative finance, I am familiar with how “quality”, for some investors, has become synonymous with a narrow mathematical definition. I think of this a bit like choosing a life-partner based on their MENSA test results (or perhaps some other critical statistic that gets your pulse racing). It might influence your decision, but it is unlikely to tell you everything that you need to know.
Within investing a company’s return on equity, or return on invested capital, have become the go-to measures of quality. Both express the size of company profits, relative to the financial resources required to generate them. By way of example, the MSCI Quality index goes a bit further, using a combination of return on equity, a company’s debt to equity ratio and the variability of its profits. Basing investment decisions on such metrics make sense for portfolios that hold many stocks, but in a more concentrated portfolio I believe that such narrow definitions are inadequate. As far as the life partner analogy goes, I’d advocate for a concentrated portfolio of one, where narrow definitions make no sense at all!
The specific risk with a narrow definition of quality becoming popularised, is that it influences the behaviour of company management and sets up a feedback loop. I see some risk that this has already happened with a measure like return on equity. A company management that takes on additional debt to repurchase their shares, will see their return on equity increase. This type of “mortgaging the family farm” will work during the good times, but risks creating problems during lean years, which runs counter to the idea of “quality”.
The philosophical message behind this is that financial markets are not part of the natural world but are social constructs. The ability for theories to feedback and influence behaviours is the reason why I do not believe there are immutable laws that govern markets.
When evaluating the quality of a business we look at quantitative measures, but also want to understand the context behind them. For some businesses certain accounting measures can be based on rather flaky logic. An example of this is that within bank accounting rules, a company can elect to hold fixed income investments for sale or until they mature. In the former case they must immediately recognise a loss in value from rising interest rates, whereas if they decide on the latter, they can ignore it. This means that a bank with a high return on equity could be of superior quality or might just be adept at gaming the accounting rules!
We place importance on qualitative measures of quality, many of which look at company management. We like companies where there is a clear alignment of interest between management and shareholders. This means that we like companies where executives and directors have large shareholdings. A particular favourite of mine is to look at the clarity and credibility of a CEO’s communication. Does what they say make sense or is it devoid of content and overladen with jargon?
The nature of a company’s business model also tells us a lot about its quality. We like companies that have strong competitive positions, where it is hard for competitors to “eat their lunch”. We are not alone in this regard, and the Buffett/Munger characterisation of looking for companies with “wide moats” has well and truly entered the investment management lexicon.
The financial markets have no shortage of intelligent and competitive individuals, and so it is to be expected that any company that is obviously “high quality” will command a premium. Our investment approach is to place equal importance on the price that we pay to the quality of what we are buying. Hence, we generally find ourselves in a trade-off between the quality of a company and how cheap its share price looks.
With a growing number of investors chasing the very “best” quality, such companies have commanded increasingly steep premiums. Our response to this has been to invest in cheaper companies where we convince ourselves that the underlying business is of “decent” quality. However, we have also bought some “not so cheap” businesses because we think they are “really good” quality. It is hard to characterise this with words alone, and so measures like the portfolio level price earnings ratios give a less ambiguous guide as to the situations we are investing in.
If I was to summarise my views on quality – it is that it is in the eye of the beholder. Furthermore, a good business only makes for a good investment at the right price.