‘Quality investing’ is the style pursued by the world’s greatest investor Warren Buffett, who recently announced his retirement as chief executive of Berkshire Hathaway (BRK.B:NYSE) after more than sixty years presiding over the Omaha-based investment powerhouse.

Buffett’s focus on only buying quality companies has been the bedrock of Berkshire’s success - since 1965, the shares have increased in value by 5,502,284% compared with a gain of slightly over 39,000% for the S&P 500 over the same period.

So quality investing has generated strong long-term returns for its practitioners, but how do we actually define quality?

SIMPLY THE BEST

In short, quality investors focus on profitability, financial strength and stability when assessing companies.

Quality investing entails putting money to work with best-in-class businesses which 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.

However, 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.’

Measuring quality often involves evaluating both quantitative financial metrics, those hard criteria which gauge a company’s fiscal strength and stability, as well as the qualitative aspects of a company, those soft criteria such as the pedigree of the management team, its corporate culture, and the strength of its brands and pricing power.

For instance, US tech titan Microsoft (MSFT:NASDAQ) is able to raise prices without triggering a significant switch to competitor products because companies are so reliant on Microsoft Office.

USEFUL TOOLS

One useful framework for evaluating the competitive forces at work in an industry is ‘Porter’s Five Forces’ – competitive rivalry, supplier power, buyer power, threat of substitution and threat of new entry – which can help investors to gauge where a company sits in the competitive environment.

Another measure often employed by quality investors is ROCE or return on capital employed.

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 useful rule of thumb is a ROCE of 15% or higher is reflective of a quality business and is almost certain to mean it is generating a return above its WACC.

One further gauge of a company’s profitability and its efficiency in generating profits is return on equity, or ROE, which is calculated by dividing net annual income by shareholders’ equity and multiplying the result by 100 to get a percentage figure.

Other metrics which are marks of quality include strong gross and operating margins, high returns on invested capital (ROIC) and healthy free cash flow conversion.

Financially-strong companies also tend to require little debt to finance their operations, so a net cash balance sheet is another indicator of a quality business.

VALUATION MATTERS

As with everything in life, price is what you pay, value is what you get, and if you overpay for a stock - even if the company is high-quality - you aren’t getting good value, which means your long-term returns will be sub-optimal.

Generally speaking, it shouldn’t be possible to find great companies at great prices, because the stock market is made up of millions of investors all looking for bargains, and when they find one its price should rise as everyone tries to get in on the action.

Markets aren’t that efficient, though, and as investors we also have in-built biases, so quite often we will overlook companies whose shares are cheap believing they must be low-quality.

By first identifying which companies are high-quality and which ones aren’t, and then applying a systematic valuation process, we have come up with three stocks which we believe represent the best of both worlds - businesses which can sustainably generate significantly above-average returns but are priced at a substantial discount to their historic average.

Once the market begins to price these stocks correctly and the mean reversion process kicks in, the upside to their historic average multiples - which is our base case - ranges from 75% to more than 120%.

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AB Dynamics (ABDP:AIM)

Price: £18.75

Market Cap: £425 million

Quality financial metrics jump off the page at AB Dynamics (ABDP:AIM), a leading provider of development, test and verification solutions to the global transport market.

The business generates healthy operating margins in the high teens percent and throws off plenty of cash allowing the company to invest in innovation, make bolt-on acquisitions in high-return niche areas and return capital to investors via a progressive dividend policy.

Free cash flow per share has grown by 35% per year since 2019 while dividends have grown by 12% per year, and there is plenty of scope to increase the payout given it is covered more than eight times by earnings.

Great financial metrics are only valuable if they can be sustained, however, and there are good reasons why AB Dynamics can continue to deliver.

The company holds a leading position in a growing market supported by tailwinds of increased regulation and the transition to electrification, added to which it has a diverse customer base and high-quality relationships.

The number of Euro NCAP (European New Car Assessment Programme) tests is expected to increase from 450 today to around 1,000 by 2030, which should support demand for the company’s services.

Higher complexity associated with EVs will drive demand for the company’s products and services together with incremental use of simulation across new geographies and vehicle categories.

Speed to market and cost efficiencies offered by simulation will also drive adoption of the company’s range of services.

Operationally, the group’s scalable platform means it can drive higher margins through operating leverage as well as benefiting from improvements in the supply chain, while the proportion of recurring revenue has increased to 45% from just 8% four years ago, providing greater stability and visibility.

Over the last decade, AB Dynamics has grown its EPS (earnings per share) at a compound annual growth rate of 18% a year. Meanwhile, the cyclically-adjusted PE (price to earnings) ratio of 18 times sits well below the historical average of 37 times, meaning if the shares were to revert to fair value they would be worth around £30. [MG]

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Gamma Communications (GAMA)

Price: £11.20

Market Cap: £1.05 billion

At the beginning of this month, Gamma Communications (GAMA) celebrated an important milestone as the shares graduated from AIM to the main market meaning the company was eligible for inclusion in the FTSE 250 index.

‘Since our admission to AIM in 2014, we’ve delivered strong financial and operational growth, transitioning from a UK-based company into a leading European business,’ said chief executive Andrew Belshaw.

‘As an established business with a strong track record for high recurring revenue, strong margins and high cash generation, we believe the move to the main market will best support the delivery of our long-term strategy and offers the appropriate listing for a company of our scale and ambition.’

For the uninitiated, Gamma provides telecom, internet and cloud services to UK and European businesses, and has a tremendous record of growth.

Sales and earnings have compounded at a double-digit rate in the decade to 2024, with the firm posting 11% growth in group revenue last year to £580 million and 14% growth in pre-tax profit to £112 million.

Among the group’s growth drivers, customers are increasingly asking for more complex communications solutions, which are higher-value, while the switch-off of the PSTN (Public Switched Telephone Network) in the UK will drive millions of consumers and small businesses to find other solutions.

Meanwhile, the German cloud market – which is the largest in Europe – is still underpenetrated, and Gamma’s recent acquisitions have given it the scale to make it the leading ‘challenger’.

While it prioritises investing in its businesses, both in terms of R&D and bolt-on acquisitions – which are typically earnings-enhancing from day one – Gamma has consistently increased shareholder returns both through the dividend and share buybacks.

Since listing, the annual dividend has risen from 6.6p to 19.5p per share, and earlier this year the company announced it would undertake a £50 million buyback having already repurchased £27 million worth of shares last year.

Assuming it continues to compound earnings at the current rate, we believe a fair price for the shares 12 months from now would be around £26 or close to double the current share price. [IC]

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Kainos (KNOS)

Price: 805p

Market Cap: £980 million

It has been an uncomfortable couple of years for Kainos (KNOS), but the tide is finally turning. 

The stock has risen 20% in the past month, 37% from recent multi-year lows below 600p, yet it still trades at a near-40% discount to its 12-month peak and more than a 50% discount to the all-time peak of over £20.

The Belfast-based software and digital transformation specialist is a FTSE 250 business which essentially does three things.

Digital Services helps typically large organisations transition their processes and operations into the 21st century digital world and is a key supplier to UK government departments, often writing bespoke tools and software.

The firm’s £50 million contract with the UK Ministry of Defence, to support the MoD’s Defence Data Analytics Platform, a centralised data sharing platform and ecosystem of related tools, was its first double-digit public sector win since it secured a combined £53 million of deals with NHS England and the UK Health Security Agency, and crucially suggests that the ice age of new contract awards since the election has begun to ease.

Then there’s its Workday (WDAY:NASDAQ) practice, in partnership with the $71 billion US enterprise human resources and financial planning software platform, which provides clients with testing, training, installation and audit for the platform, as well as designing new products to enhance the Workday platform.

Over the years, Kainos has earned a reputation as a high-quality business built on consistently strong execution and service delivery and on Stockopedia’s ranking system it scores 98/100 for quality. 

High staff retention and customer satisfaction have driven best-in-class net revenue retention in an above-average growth market.

Analysts estimate the UK’s digital services market will expend to £5.2 billion by 2027, while Kainos’s two Workday divisions are positioned to benefit from the performance of the software giant’s own rapid growth.

Workday has grown its revenues at a compound 18% per year since 2020, while Kainos’s own growth over the same period is over 20% per year on average, with net profit increasing 23.5% annually.  

Going forward, there are positive signs of margin improvement, and while this remains undoubtedly a growth story, the stock also pays an attractive 3.5% income yield so investors get paid as the business builds. [SF]

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QUALITY-FOCUSED TRUSTS AND FUNDS

Examples of quality-focused trusts and funds include the hugely popular Fundsmith Equity (B41YBW7). Manager Terry Smith looks for businesses which can sustainably deliver high returns on capital and which have growth opportunities to reinvest those returns.

Smith has a bias towards companies with a degree of predictability and looks for names which generate revenue from a large number of everyday, predictable transactions. He’s also looking for a management team which has skill in terms of capital allocation.

Boutique asset manager Sanford DeLand’s CFP SDL UK Buffettology (BF0LDZ3) and CFP SDL Free Spirit (BYYQC27) funds are run according to the philosophy of ‘Business Perspective Investing’, the successful strategy associated with Warren Buffett and other disciples of legendary investor Ben Graham.

Free Spirit manager Eric Burns and Buffettology manager Keith Ashworth-Lord both put a lot of faith in ‘Porter’s Five Forces’ (see main article).

Other collectives with a focus on quality include JPMorgan Global Growth & Income (JGGI). This increasingly prominent investment trust, which has absorbed several other trusts in recent years, looks for the best companies wherever they are listed and focuses on high-quality, cash-generative businesses which won’t be knocked off course by fluctuations in the economy or competitive landscape.

Though recent performance has been fairly uneven, ‘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.

Elsewhere, 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.

Disclaimer: The editor (Ian Conway) owns shares in Fundsmith Equity.

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