‘Quality investing’ is the style pursued by the world’s most famous investor Warren Buffett and Terry Smith, arguably the best-known British fund manager who runs the five-star Morningstar-rated Fundsmith Equity (B41YBW7) and consistently favours quality firms. Quality investing has generated strong long-run returns for its practitioners, including Buffett, but how do the leading fund managers offering private investors exposure to the style actually define quality?

QUALITY INVESTING DEMYSTIFIED

Put simply, quality investors focus on profitability, financial strength and stability when assessing companies. Quality investing entails putting money to work with best-in-class businesses that have the ability to generate consistent returns over the long term and can protect and grow their value across market cycles. Investors should expect to pay more for a quality business, since shares in these durable firms are highly prized and rarely, if ever, cheap. But as the classic Buffett quote goes: ‘It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.’

HUNTING FOR HIGH RETURNS

Terry Smith seeks out companies with sustainably high returns on capital and crucially, a source of growth to invest those good returns back into. The no-nonsense East End native favours businesses with a degree of predictability – Smith is a fan of companies that make money from a large number of everyday, predictable transactions – and also looks for a degree of management skill in terms of capital allocation.

Names passing muster with Smith range from Microsoft (MSFT:NASDAQ) and Novo Nordisk (NOVO-B:CPH)) to Visa (V:NYSE) and LVMH (MC:EPA).

Sanford DeLand manages the CFP SDL UK Buffettology (BF0LDZ3) and CFP SDL Free Spirit (BYYQC27) funds according to the philosophy of ‘Business Perspective Investing’, the successful strategy associated with Buffett and other Ben Graham disciples.

‘Quality is right at the top of what we do,’ says Eric Burns, Sanford DeLand’s chief analyst and manager of running Shares Great Ideas pick CFP SDL Free Spirit. ‘We are primarily business analysts looking for quality businesses and there are two aspects to it, the qualitative side and the quantitative side, and the two go hand in hand.’

On the qualitative side Burns and Buffettology manager Keith Ashworth-Lord place great store in ‘Porter’s Five Forces’, a framework for understanding the competitive forces at work in an industry – the five forces include competitive rivalry, supplier power, buyer power, threat of substitution and threat of new entry – in order to gauge where a company sits in the competitive environment. ‘Is it going to be around in 10 years’ time, get eroded away by competition, or it beholden to suppliers?’, are the questions Burns needs to answer.

‘High returns on capital and high return on equity are the marks of a quality business,’ he informs Shares. ‘Because if a company can earn a return over and above its cost of capital it is creating value for the shareholder. Ultimately that is what’s going to generate your long-term return. A business that is not generating an adequate return is going to destroy value over time.’

Burns and Ashworth-Lord focus on ROE (return on equity) as the main metric rather than ROCE (return on capital employed). ‘It is all very well generating a return on your capital, but for us it has got to be a cash return. We are only interested in businesses that have a high cash conversion rate, anything over 80% as a starting point,’ stresses Burns, who also looks for robust balance sheets (most of the companies in Free Spirit have net cash).

‘On the quantitative side, the business ought to be growing,’ says Burns, who highlights Buffettology holding Rightmove (RMV) as a business ‘growing the top line at a decent rate. We also look at sales and profit per employee, which tells you if management is expanding the business in a sensible way. I would struggle to think of a higher quality business on the UK market than Rightmove. Over five years, Rightmove’s return on average capital employed is 297%, if only they could all be that good. Cash conversion is exemplary and since Rightmove doesn’t have a cost of goods sold, its 100% margin at the gross level.’

RESILIENCE IN TOUGH TIMES

Tomasz Boniek, who supports James Harries in managing the STS Global Income & Growth Trust (STS), says a quality company must have three attributes: strong financial productivity, a well-defined and sustainable growth opportunity and a good management team. ‘When we think about financial productivity, we look at metrics like gross margin, operating margin, return on invested capital (ROIC) and free cash flow conversion. Companies that are financially strong also tend to require little debt to finance their operations, which leads to resiliency in tough economic conditions, a key attribute of all Troy Funds.’

Boniek also firmly believes that extensive qualitative analysis is required to understand why a company is financially productive. ‘Specifically, we like to see companies that have a strong competitive position, either because of demand-side advantages (brand, product quality, consumer lock-in) or supply-side advantages (low-cost provider, unique operating model). Finally, quality companies generate significant amounts of excess cash. How a management team distributes this cash matters greatly for investment returns. We dislike strategic acquisitions, and we favour companies that reward shareholders via dividends without compromising the company’s ability to reinvest back in the business.’

DON'T DISMISS VALUATION

‘We look for sustainable high growth, including margins, returns on investment and cash flows,’ says Gerrit Smit, portfolio manager of the Stonehage Fleming Global Best Ideas Equity Fund (BCLYMF3), which also homes in on qualitative measures like company culture and management expertise when building the fund’s portfolio.

‘Valuation remains critical for us,’ Smit adds, but rather than focus purely on the next 12 to 18 months, the Stonehage Fleming manager believes three-year PEG ratios (price to earnings growth) give a better measure of a stock’s compounding growth potential.

But being such a stickler for value can mean missing out on some very good opportunities, Smit admits. ‘We missed good returns on Apple (AAPL:NASDAQ) because we didn’t have the conviction on organic growth and valuation,’ he says. Industrial cleaning company Cintas (CTAS:NASDAQ) is another stock that missed the cut. ‘At 35-times PE, we underestimated the growth potential, ’ he says. ‘Now it trades on a PE of 40.’

NICHE MARKET LEADERS

Ed Wielechowski, who manages Odyssean Investment Trust (OIT) alongside Stuart Widdowson, tells Shares. ‘We think about business “quality” across three different areas, i) financial characteristics; ii) market and value chain position; and iii) management team - looking for a range of quantitative and qualitative factors across these areas. Financial metrics we look for, include high and consistent cash return on capital employed and sustainable debt levels (relative to cash generation). On market position, we like to find niche market leaders, with a strong economic moat which enjoy pricing power. Finally, we look for management teams with proven track records, skillsets and incentives that match the shape of our expected equity story. Quality for us is where all three elements come together – an attractive financial model, a strong market position and capable team.’

FOUR QUALITY PICKS

We used a mixture of our own knowledge and intuition and screening tools to identify four quality names which we think could reward shareholders over the long term. They span a variety of different sectors and countries and come from different parts of the market cap spectrum. Read on to discover our selections.

Joe Bauernfreund, CEO & CIO - Asset Value Investors

‘Many so-called value investors are drawn to companies that are priced cheaply by the market. Often, these companies trade cheaply for a reason,’ says Joe Bauernfreund, CEO & CIO of investment manager Asset Value Investors.

‘A classic example is a conglomerate owning one good business and one poor quality business. The conglomerate as a whole trades at a discount to its theoretical sum of the parts value, but in many respects, this is an example of the market being efficient. The conglomerate trades at a discount because the poor-quality business is likely to continue to depreciate in value, and it becomes a race against time for that business to be monetised before it declines further in value, dragging down the sum of the parts value.

‘At AVI we aim to avoid these kinds of situations. The discounted valuations we exploit will typically be in companies where we believe that the sum of the parts value is likely to increase over time, and this leads us to invest in good quality/growing businesses, but at discounted valuations. “Good quality” therefore reflects our belief that a particular business will continue to grow its profits and hence see its value appreciate. Businesses with market-leading positions; high margins and a track record of consistent growth would meet our criteria.’

Quality factor ETFs

Low-cost exposure to quality stocks is possible through exchange-traded funds (ETFs for short). There are several vehicles which apply quality factors to different countries and regions and some which have a sustainability or income skew too. A product like iShares Edge MSCI World Quality Factor (IWFQ) gives you global exposure and is a good example to compare with an ETF which simply tracks the broad MSCI World index like  iShares Core MSCI World (SWDA).

The quality-focused ETF has delivered modest but still material outperformance versus the broader-based alternative on a five-year view, 13% versus 12.4% on an annualised basis, though this does come at a higher ongoing charge of 0.3% versus 0.2% for its more vanilla counterpart.

Rough calculations suggest even with the disparity in charges you would still have generated a better return with the quality factor instrument.

The underlying MSCI World Quality Factor index is built to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity, stable year-over-year earnings growth and low levels of borrowing. It covers around 20% of the overall MSCI World index and the subset of stocks is unsurprisingly more expensive than the broad index.

As the rest of this article explores, there’s more to identifying quality stocks than just crunching numbers and some global, actively managed funds and investment trusts with a focus on quality have delivered a better return than the iShares Edge MSCI World Quality Factor. For, example, popular quality play JPMorgan Global Growth & Income (JGGI) has served up an annualised return of 15.5% (albeit at a significantly higher ongoing charge of 0.63%).

Many active quality funds though will have fallen short even of the straight MSCI World given the exceptional performance of the big tech names which have dominated this index in recent times. [TS]

Average price to earnings ratio of iShares Core MSCI World constituents: 21.7 times

Average price to earnings ratio of iShares Edge MSCI World Quality Factor constituents: 25.2 times

Broadcom (AVGO:NASDAQ) $1,413.09

Ubiquity and quality are often pretty comfy roomies, so when your kit dominates the communications and connectivity world, investors should take note of Broadcom (AVGO:NASDAQ). This is a Silicon Valley-based semiconductor and infrastructure software producer whose chips see an estimated 99% of all internet traffic pass through them.

It is also one of the world’s leading custom silicon developers, working closely with customers like Alphabet (GOOG:NASDAQ), for example, to create application-specific chips that deliver superior performance and energy efficiency at lower cost for targeted workloads. On its infrastructure software side, Broadcom shuns the growth-at-any-cost approach and, according to Blue Whale Growth’s (BD6PG78) Stephen Yiu, chooses to work with its largest 600 to 700 customers to expand their use of its software, resulting in a highly attractive margin profile.

Gross margins run close to 70% and operating margins around 36%, although the later have been well over 40% in the past. Structural tailwinds behind the sector combined with the firm’s pragmatic business approach have led to years of superior returns – Morningstar calculates an average yearly return of 36% over the past decade, more than twice that of the Nasdaq. More of the same is anticipated, and by fiscal 2025 (to end October), net profit is seen roughly doubling 2023’s $14 billion. This makes a three-year averaged forward PE (price to earnings) multiple of 25 look attractive, in our view. [SF]

DISCLAIMER: Steven Frazer owns a personal stake in Blue Whale Growth.

ROCE & ROE

A measure that is often employed by quality investors return on capital employed (ROCE). To generate value for its shareholders a business should be looking to generate a ROCE which is consistently ahead of its weighted average cost of capital (WACC). Translated into plain English this means it needs to make a bigger return on the money spent funding the business than the average cost of that funding (from both debt and equity). A good rule of thumb is that a ROCE of 15% or more is reflective of a decent quality business and this is almost certain to mean it is generating a return above its WACC. ROE (return on equity), calculated by dividing net annual income by shareholders’ equity and multiplying the result by 100 to get a percentage, is a gauge of a company’s profitability and its efficiency in generating its profits.

Gamma Communications (GAMA:AIM) £14.70

Rallying 33% this year, Gamma Communications (GAMA:AIM) is, we believe, a unique play on integrated IT and communications on the UK market. Developing in-house designed, often bespoke kit using cloud technology helps organisations to get the best out of 21st century connectivity.

Shifting to cloud communications has been in play for several years but we know that the pandemic hastened the shift for most organisations hoping to embrace greater flexibility and cost efficiency. Gamma already has significant scale, selling both direct to enterprises and through third-party resellers, and we would expect the company to continue expanding its offering, creating an increasingly compelling value and service-based proposition.

That it has a habit of out-competing both large and small rivals in what is increasingly known as the unified communications-as-a-service industry, or UCaaS for short, is additional proof of its quality credentials, but there is scope to improve returns on capital and equity (both high-teens) and operating margins (12.8% in 2023) back to previous peaks.

Gamma is a stock well known to Shares – we have followed it right from IPO (initial public offering) nearly a decade ago, and were so taken by its sustainable quality growth and cash generation story that we made it one of our top picks for 2015. That was at 231.5p – it now trades 535% higher, so it’s done quite well. But considerable further upside remains on the cards. [SF]

Tristel (TSTL:AIM) 445p

Based near Cambridge, Tristel (TSTL:AIM) is a company focused on preventing the transmission of microbes from one object or person to another.

The company provides high level disinfection for medical devices used in non-invasive procedures such as ultrasound scans and sporicidal disinfection of surfaces.

Tristel has developed a patent protected proprietary disinfectant technology utilising chlorine dioxide. The company is unique in using its formulation as a high-performance disinfectant on medical devices via manual application of the chemistry.

This method eliminates the need for capital investment by hospitals in automated machines to perform the same disinfection and requires no water or electricity, saving time and money. Tristel generates revenue from selling consumables.

Patent protection provides sustainably high gross margins of around 80% which translates into healthy returns on invested capital and strong cash flow generation (around 22% of revenue), all financial markers of a high-quality business. The company has net cash on the balance sheet.

In June 2023 the company secured US regulatory approval giving it access the world’s largest market for ultrasound scans, underpinning its next leg of growth. The shares trade on a forward PE (price to earnings) ratio of 31 times, falling to 26 times for 2025. [MG]

Wolters Kluwer (WKL:AMS) €150

Dutch business services company Wolters Kluwer (WKL:AMS) provides information and software solutions to the legal, business, tax, accounting, audit, risk, compliance and healthcare markets, making it something of a cross between data cruncher Experian (EXPN) and publisher RELX (REL).

With a market cap close to €38 billion, it is one of the biggest quoted companies in Europe and a member of the Stoxx 50 benchmark.

The firm had a good start to 2024 with organic first-quarter sales up 6%, of which 82% came from recurring revenue, including a 16% increase in cloud software revenue.

For the full year, the company is expecting an operating profit margin of 26.4% to 26.8%, a return on invested capital of 17% to 18% and EPS (earnings per share) growth of mid- to high single-digits, all of which are highly respectable metrics.

The full-year earnings growth estimate tallies with our own work, which suggests that since the late 1980s Wolters has compounded EPS at around 9% per year.

That compares with just over 5% for RELX and around 7% for Experian, both of which trade more than one standard deviation above their 35-year average valuation on cyclically-adjusted earnings due to AI hype whereas Wolters – which is also an AI Player – is trading around its average. [IC]

QUALITY-FOCUSED COLLECTIVES

Other professionally managed portfolios with a fervent quality focus include JPMorgan Global Growth & Income (JGGI), the popular investment trust whose managers look for the best companies wherever they are listed and focus on high-quality, cash-generative businesses which won’t be knocked off course by the economy or competitive forces.

Though he is currently licking his wounds following a period of underperformance, ‘buy-and-hold’ investor Nick Train’s Finsbury Growth & Income (FGT) offers exposure to a concentrated portfolio of durable, cash generative companies with high returns on equity. And in the funds patch, Blue Whale Growth’s (BD6PG78) global approach allows manager Stephen Yiu to look into every corner of the world for what he deems to be the best possible companies available.

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