Debunking three major misconceptions about what makes a company quality

10 Aug 2017
Unlike well-defined investment strategies such as Value and Growth investing, there is still no universally agreed upon definition of Quality, despite it being an investment strategy that continues to gain traction due to its ability to add long-term value in the context of increasingly volatile and uncertain markets. 

Moosa Hassim, Investment Analyst at Old Mutual Wealth Private Client Securities, says that it is as a result of this lack of collective classification, that various misconceptions exist around what makes a quality company “quality”.

“Quality investing - the investment into companies that are believed to have a consistent record of strong business performance and prospects of long-term financial growth - is based on an understanding of the factors that influence a company’s performance over the longer term. Contrary to popular belief, however, a Harvard Business Review study based on the historical performance of close to 5000 companies confirms that a company’s age, size, and industry are in fact not among the factors that are accurate predictors for long-term stable growth.”

Having debunked these common “quality myths”, he goes on to explore the quality criteria and methodology by which he believes stock purchases should be evaluated. “In terms of defining quality, we have what we like to call our ‘three quality lenses’ which allow us to cast a critical eye on the company to ensure that we understand all aspects of how it functions and essentially what makes it tick. These lenses are financial strength, profitability and qualitative analysis.”

The first two factors are quantitative in nature and therefore quite easily defined, says Hassim. “Financial strength broadly refers to the strength of a company’s balance sheet, as most financial crises can be traced back to a foundation of weak balances sheet that were not able to withstand the pressures of excessive debt.

“With regards to the second lens, profitability, there are three factors that indicate quality, namely strong, predictable cash generation; sustainably high returns of capital; and attractive earnings growth. Each of these traits is very powerful individually, but when combined, this power is multiplied significantly,”

Lastly, Hassim touches on qualitative analysis, which he says allows an investor to dig deeper into a company and get a full understanding of what makes it tick. “Under the broad heading of qualitative analysis, we have four subheadings which we believe can be used to predict the success of a quality company. These factors, which are in no particular order of importance, should be looked at holistically.

“The first factor, growth prospects, may seem an obvious one, but it is worth noting that opportunities for growth maximise the benefits derived from high returns on capital. The second of these qualitative factors is an appealing industry structure, which, as opposed to using an industry itself to infer quality, refers to how a company is positioned within its industry.”

“The next qualitative factor is competitive advantage, or as we like to call it, economic moat, which measures a company’s ability to maintain competitive advantages over its competitors in order to protect long-term profits and market share from competing companies. A company which we believe to have a very wide economic moat is Facebook, as its strength lies in the network effect around its massive user base across its various platforms, from Instagram to WhatsApp.”

The last qualitative factor that Hassim unpacks is that of management. “A strong management team has the ability to navigate a company through the harshest of times. Management depth and experience, a solid track record of delivering on key metrics and clear articulation of future strategy and targeted results are all criteria that we believe indicate a quality company.

“At Old Mutual Wealth Private Client Securitise, we combine a top-down methodology with bottom-up stock selection to build resilient portfolios with the objective of generating attractive long-term returns by minimising risk. Top-down analysis is long term and secular in nature, incorporating analysis of economies and markets, while our bottom-up selection focuses on strong fundamentals combined with quality characteristic.”

Hassim concludes that it is important to remember that quality investing requires time and patience. “Quality investing is a defensive strategy, and it is during periods of slow growth that quality companies truly outperform. It is therefore important to ride out short-term periods of volatility and underperformance, as true quality companies will always outperform over the long term.”