The world is a big place. This will become readily apparent when faced with the daunting task of deciding which companies to invest in. Perhaps you noticed a company that has been performing incredibly well and has grown ten-fold in just a few years. Other companies may have looked rather cheap for some time now and a recent price fall only enhances their appeal. Regardless, you are likely left with the same lingering question, what companies should I invest in?
One factor, some may even refer to it as style, that is often overlooked is that of quality. Probably the main reason it is not front of mind is that the concept of quality is not so readily defined and can become quite subjective. Depending on who you ask, the answer may not always be the same, often varying in characteristics and terms. Common answers to the question may include “good management”, “possesses financial strength”, often denoted by a solid balance sheet, the words “attractive growth” may be thrown in and even the term “competitive advantage”. In their own right, these terms can be open for interpretation, further supporting the notion that quality a subjective factor. This is not necessarily a bad thing as those that are a better judge of quality will hold some advantage in this area.
However, to help us understand the concept of quality a little better we can turn to those who have actually written a book on the subject called, unsurprisingly, “Quality Investing”. In their book, authors Cunningham, Eide and Hargreaves define quality companies as having three core characteristics: predictable cash generation, sustainably high returns on capital and attractive growth opportunities.
Some may argue that the final characteristic of attractive growth may not be necessary in that a company that is able to consistently generate high returns on capital and produce strong, consistent cash flows can return the cash to investors in the form of dividends or share buybacks rather than reinvesting back into the business. For some, healthy distributions such as these from a company are all that is needed but there is something to be said for reinvesting in growth opportunities at high rates of return.
As the authors note, the ability to reinvest cash generated back into growth opportunities with high returns on capital creates a powerful virtuous cycle as it will to lead to even greater cash generation and the cash can once again be reinvested. Companies that are able to do this are wealth compounding machines.
As the saying goes, “price is what you pay, value is what you get”. With this in mind, it is important to point out that the market is not blind to the compounding powers of these companies and their desirability means that they often trade a premium, at least to the general market. For an investor to generate a suitable return on their investment in a company, it is critical that they do not pay more than what something is worth. Perhaps this is where investing transforms from a science to an art – or is it the other way round if your paint brush is a calculator.
Whilst the market attaches a premium to these stocks, often the premium may be too small. The best wealth compounders are able to sustain their high returns on capital for much longer than many market participants might think and these companies can continue to generate high, stable returns on capital for incredibly long periods of time. The lack of appreciation of this concept leads many to underestimate the potential value of these companies. What this does not imply is that all quality companies are undervalued. Rather, one is better served taking a long-term view on a company when trying to determine its value, factoring in the company’s ability to sustainably maintain its high returns on capital whilst still being able to reinvest in attractive growth opportunities.