Quality investing
Encyclopedia
Quality investing is an investment strategy
based on clearly defined fundamental factors that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet
stability). Quality Investing supports best overall rather than best-in-class approach.
and real estate investing
, where both the quality and price
of potential investments are determined by rating
s and expert attestations. Later the concept was applied to enterprises in equity markets.
Benjamin Graham
, the founding father of value investing
, was the first to recognize the quality problem among equities back in the 1930s. Graham classified stocks as either quality or Low quality. He also observed that the greatest losses result not from buying quality at an excessively high price, but from buying Low quality at a price that seems good value.
The quality issue in a corporate context attracted particular attention in the management economics literature following the development of the BCG matrix
in 1970. Using the two specific dimensions of life cycle
and the experience curve concept
, the matrix allocates a company's products
– and even companies themselves – to one of two quality classes (Cash Cows
and Stars) or two Non-quality classes (question Marks and Dogs). Other important works on quality of corporate business can be found primarily among the US management literature. These include, for example, "In Search of Excellence
" by Thomas Peters
and Robert Waterman
, "Built to Last
" by Jim Collins
and Jerry Porras
, and "Good to Great
" by Jim Collins.
Quality investing gained credence in particular after the burst of the Dot-com bubble
in 2001 when investors witnessed the spectacular failures of companies such as Enron
and Worldcom. These corporate collapses focused investors’ awareness on quality, which may vary from stock to stock. Investors started to pay more attention to quality of balance sheet, earnings quality
, information transparency, corporate governance
quality.
1. Market Positioning: quality company possesses an economic moat, which distinguishes it from peers and allows to conquer leading market position. The company operates in the industry which offers certain growth potential and has global trends (e.g. ageing population for pharmaceuticals industry) as tailwinds.
2. Business model
: According to the BCG matrix, the business model of a quality company is usually classified as star (growing business model, large capex) or cash cow (established business model, ample cash flows, attractive dividend yield). Having a competitive advantage, quality company offers good product portfolio, well-established value chain
and wide geographical span.
3. Corporate Governance
: Evaluation of corporate management execution is mainly based on soft-criteria assessment. Quality company has professional management, which is limited in headcount (6-8 members in top management) and has a low turnover rate. Its corporate governance structure is transparent, plausible and accordingly organized.
4. Financial Strength: Solid balance sheet, high capital and sales profitability
, ability to generate ample cash flows are key attributes of quality company. Quality company tends to demonstrate positive financial momentum for several years in a row. Earnings are of high quality, with operating cash flow
s exceeding net income
, inventories and accounts receivables not growing faster than sales etc.
5. Attractive valuation: Valuation ultimately is related to quality, which is similar to investments in real estate. Attractive valuation, which is defined by high discounted cash flow
(DCF), low P/E ratio
and P/B ratio
, becomes an important factor in quality investing process.
According to a number of studies the company can sustain its quality for about 11 months in average, which means that quantitative and qualitative monitoring of the company is done systematically.
and growth Investing
. A quality portfolio may therefore also contain stocks with Growth and Value attributes.
Nowadays, Value Investing is based first and foremost on stock valuation
. Certain valuation coefficients, such as the price/earnings and price/book ratios, are key elements here. Value is defined either by valuation level relative to the overall market or to the sector, or as the opposite of Growth. An analysis of the company's fundamentals is therefore secondary. Consequently, a Value investor will buy a company's stock because he believes that it is undervalued and that the company is a good one. A quality investor, meanwhile, will buy a company's stock because it is an excellent company that is also attractively valued.
Modern Growth Investing centers primarily on Growth stocks. The investor's decision rests equally on experts' profit forecasts and the company's earnings per share
. Only stocks that are believed to generate high future profits and a strong growth in earnings per share are admitted to a Growth investor's portfolio. The share price at which these anticipated profits are bought, and the fundamental basis for growth, are secondary considerations. Growth investors thus focus on stocks exhibiting strong earnings expansion and high profit expectations, regardless of their valuation. Quality investors, meanwhile, favor stocks whose high earnings growth is rooted in a sound fundamental basis and whose price is justified.
Investment strategy
In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio...
based on clearly defined fundamental factors that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
stability). Quality Investing supports best overall rather than best-in-class approach.
History
The idea for quality investing originated in the bondBond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
and real estate investing
Real estate investing
Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. Improvement of realty property as part of a real estate investment strategy is generally considered to be a sub-specialty of real estate investing called real estate development...
, where both the quality and price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
of potential investments are determined by rating
Rating
A rating is the evaluation or assessment of something, in terms of quality , quantity , or some combination of both.Rating may also refer to:...
s and expert attestations. Later the concept was applied to enterprises in equity markets.
Benjamin Graham
Benjamin Graham
Benjamin Graham was an American economist and professional investor. Graham is considered the first proponent of value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book...
, the founding father of value investing
Value investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
, was the first to recognize the quality problem among equities back in the 1930s. Graham classified stocks as either quality or Low quality. He also observed that the greatest losses result not from buying quality at an excessively high price, but from buying Low quality at a price that seems good value.
The quality issue in a corporate context attracted particular attention in the management economics literature following the development of the BCG matrix
Growth-share matrix
The BCG matrix is a chart that had been created by Bruce Henderson for the Boston Consulting Group in 1968 to help corporations with analyzing their business units or product lines...
in 1970. Using the two specific dimensions of life cycle
Enterprise Life Cycle
Enterprise Life Cycle in enterprise architecture is the dynamic, iterative process of changing the enterprise over time by incorporating new business processes, new technology, and new capabilities, as well as maintenance, disposition and disposal of existing elements of the enterprise.- Overview...
and the experience curve concept
Experience curve effects
Models of the learning curve effect and the closely related experience curve effect express the relationship between equations for experience and efficiency or between efficiency gains and investment in the effort....
, the matrix allocates a company's products
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...
– and even companies themselves – to one of two quality classes (Cash Cows
Cash cow
In business, a cash cow is a product or a business unit that generates unusually high profit margins: so high that it is responsible for a large amount of a company's operating profit...
and Stars) or two Non-quality classes (question Marks and Dogs). Other important works on quality of corporate business can be found primarily among the US management literature. These include, for example, "In Search of Excellence
In Search of Excellence
In Search of Excellence is an international bestselling book written by Tom Peters and Robert H. Waterman, Jr.. First published in 1982, it is one of the biggest selling and most widely read business books ever, selling 3 million copies in its first four years, and being the most widely held...
" by Thomas Peters
Tom Peters
Thomas J. "Tom" Peters is an American writer on business management practices, best-known for In Search of Excellence .-Life and career:Peters was born in Baltimore, Maryland...
and Robert Waterman
Robert H. Waterman Jr
Robert H. Waterman Jr is a non-fiction author and expert on business management practices. He is best known as the co-author, with Tom Peters, of In Search of Excellence. He earned his MBA from Stanford University and his degree in geophysics from the Colorado School of Mines...
, "Built to Last
Built to Last: Successful Habits of Visionary Companies
Built to Last: Successful Habits of Visionary Companies is a book written by Jim Collins and Jerry I. Porras on October 26, 1994. The book outlines the results of a six-year research project into what makes enduring great companies...
" by Jim Collins
James C. Collins
James C. "Jim" Collins, III is an American business consultant, author, and lecturer on the subject of company sustainability and growth. Jim Collins frequently contributes to Harvard Business Review, Business Week, Fortune and other magazines, journals, etc...
and Jerry Porras
Jerry I. Porras
Jerry I. Porras is a professor at Stanford University Graduate School of Business and Lane Professor Emeritus of Organizational Behavior and Change....
, and "Good to Great
Good to Great
Good to Great: Why Some Companies Make the Leap... and Others Don't is a 2001 management book by James C. Collins that aims to describe how companies transition from being average companies to great companies and how companies can fail to make the transition...
" by Jim Collins.
Quality investing gained credence in particular after the burst of the Dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
in 2001 when investors witnessed the spectacular failures of companies such as Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
and Worldcom. These corporate collapses focused investors’ awareness on quality, which may vary from stock to stock. Investors started to pay more attention to quality of balance sheet, earnings quality
Earnings quality
Earnings quality, in accounting, refers to the overall reasonableness of reported earnings. It is an assessment criterion for how "repeatable, controllable and bankable" a firm's earnings are, amongst other factors...
, information transparency, corporate governance
Corporate governance
Corporate governance is a number of processes, customs, policies, laws, and institutions which have impact on the way a company is controlled...
quality.
Identification of Corporate quality
As a rule, systematic quality investors identify quality stocks using a defined schedule of criteria that they have generally developed themselves and revise continually. Selection criteria that demonstrably influence and/or explain a company's business success or otherwise can be broken down into five categories:1. Market Positioning: quality company possesses an economic moat, which distinguishes it from peers and allows to conquer leading market position. The company operates in the industry which offers certain growth potential and has global trends (e.g. ageing population for pharmaceuticals industry) as tailwinds.
2. Business model
Business model
A business model describes the rationale of how an organization creates, delivers, and captures value...
: According to the BCG matrix, the business model of a quality company is usually classified as star (growing business model, large capex) or cash cow (established business model, ample cash flows, attractive dividend yield). Having a competitive advantage, quality company offers good product portfolio, well-established value chain
Value chain
The value chain, is a concept from business management that was first described and popularized by Michael Porter in his 1985 best-seller, Competitive Advantage: Creating and Sustaining Superior Performance.-Firm Level:...
and wide geographical span.
3. Corporate Governance
Corporate governance
Corporate governance is a number of processes, customs, policies, laws, and institutions which have impact on the way a company is controlled...
: Evaluation of corporate management execution is mainly based on soft-criteria assessment. Quality company has professional management, which is limited in headcount (6-8 members in top management) and has a low turnover rate. Its corporate governance structure is transparent, plausible and accordingly organized.
4. Financial Strength: Solid balance sheet, high capital and sales profitability
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
, ability to generate ample cash flows are key attributes of quality company. Quality company tends to demonstrate positive financial momentum for several years in a row. Earnings are of high quality, with operating cash flow
Operating cash flow
In financial accounting, operating cash flow , cash flow provided by operations or cash flow from operating activities , refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities...
s exceeding net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
, inventories and accounts receivables not growing faster than sales etc.
5. Attractive valuation: Valuation ultimately is related to quality, which is similar to investments in real estate. Attractive valuation, which is defined by high discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
(DCF), low P/E ratio
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
and P/B ratio
P/B ratio
The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book value to its current market price. The calculation can be performed in two ways, but the result should be the same each way. In the first way, the company's market capitalization can be divided by the...
, becomes an important factor in quality investing process.
According to a number of studies the company can sustain its quality for about 11 months in average, which means that quantitative and qualitative monitoring of the company is done systematically.
Comparison to other investment models
Quality investing is an investment style that can be viewed independent of value investingValue investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
and growth Investing
Growth investing
Growth investing is a style of investment strategy. Those who follow this style, known as growth investors, invest in companies that exhibit signs of above-average growth, even if the share price appears expensive in terms of metrics such as price-to-earnings or price-to-book ratios...
. A quality portfolio may therefore also contain stocks with Growth and Value attributes.
Nowadays, Value Investing is based first and foremost on stock valuation
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
. Certain valuation coefficients, such as the price/earnings and price/book ratios, are key elements here. Value is defined either by valuation level relative to the overall market or to the sector, or as the opposite of Growth. An analysis of the company's fundamentals is therefore secondary. Consequently, a Value investor will buy a company's stock because he believes that it is undervalued and that the company is a good one. A quality investor, meanwhile, will buy a company's stock because it is an excellent company that is also attractively valued.
Modern Growth Investing centers primarily on Growth stocks. The investor's decision rests equally on experts' profit forecasts and the company's earnings per share
Earnings per share
Earnings per share is the amount of earnings per each outstanding share of a company's stock.In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations,...
. Only stocks that are believed to generate high future profits and a strong growth in earnings per share are admitted to a Growth investor's portfolio. The share price at which these anticipated profits are bought, and the fundamental basis for growth, are secondary considerations. Growth investors thus focus on stocks exhibiting strong earnings expansion and high profit expectations, regardless of their valuation. Quality investors, meanwhile, favor stocks whose high earnings growth is rooted in a sound fundamental basis and whose price is justified.