There are many ways in which investors come up with new stock ideas. Whether it be via perusing the charts through technical analysis, looking for low priced firms with fundamental value analysis or simply by following the ideas of others, all are common and well ingrained approaches. But one often overlooked aspect of stock selection is "quality". This is an often used word within the investment industry but somewhat hard to define.
In Quality Investing that is exactly what the authors attempt to do: explain the key characteristics of quality companies in an investment context, backed up with numerous examples gained over their decades of experience in the markets. More importantly, the book will teach you how to find these companies yourself and make some decent long-term profits.
The book began as a side project at AKO Capital, the authors' fund management firm, which currently has $9 billion of funds under management. And their views are well worth listening to. With a long-term approach, taking stakes in high quality listed companies, AKO's long-short fund has outperformed the market (MSCI Europe) by a compound annual growth rate of 6% per annum since it was founded in 2005. Amongst other things, its focus is on bottom-up stock picking and on companies with "outstanding" management teams.
What is quality?
"...even though quality cannot be defined, you know what quality is".
- Robert Pirsig in Zen and the Art of Motorcycle Maintenance
As mentioned above, "quality" is a frequently used word in equity investment. But it can be difficult to know what it actually means. In contrast, other investment approaches such as growth, value, momentum etc. have pretty well understood definitions.
So, what exactly is quality investing? To quote the authors, "Quality investing is a way to pinpoint the specific traits, ap- titudes and patterns that increase the probability of a particular company prospering over time..."
Traditional finance theory says that abnormal returns cannot be delivered by firms long-term. Instead, returns revert to the mean as the factors which have delivered excess gains are eroded away. But "quality" companies have a number of characteristics which enable them to defy the theory and consistently deliver abnormal returns over time.
Specifically, the authors note three factors which point toward quality in a company:
? strong and predictable cash gen- eration.
? sustainably high returns on in- vested capital.
? attractive growth opportunities.
While all are desirable, if a company exhibits all three traits then investors could be on to a winner. The rationale behind this is simple. If cash flow is strong and there are opportunities to make decent returns via reinvestment, then over the long term earnings will grow and the share price will follow.
The core text of the book is comprised of four chapters looking at the features of a quality investment and then looking at the "patterns" which enable quality companies to deliver strong financial results ? such as recurring revenues, pricing power and strong brands. The authors also examine potential pitfalls that companies which exhibit quality characteristics may come across, along with how investors can implement a quality investment strategy.
A quality company
To get the full range of features which a "quality" company exhibits you will have to read the book. But to give one example let's use Unilever ? also a favourite company of the fund managers Nick Train and Terry Smith, whose investment approaches are very similar to those referred to in the book.
Unilever is the FTSE 100 listed consumer goods company with a history going back over 100 years and a global presence in almost 200 countries. It is that global outlook which has driven its strong growth over the years. Brands have been built up in multiple geographies, with extensive distribution and sales networks giving a huge advantage over competitors. In Indonesia, for example, Unilever's distribution network is larger than the country's postal system. These extensive setups also enable the company to know more about its customers and launch new products more easily.
If you are in any doubt about the quality of Unilever, look at the chart below. Currently capitalised at c.£90 billion who says elephants don't gallop?
Not as easy as 1,2,3
Unfortunately, the characteristics used to identify quality companies cannot be reduced to simple quantitative measures. And those factors may change over time and within different industries. As the authors state, "Quality investing is a process of life long learn- ing rather a static prescription".
And of course a quality approach is not the only way to success in investing. Notably, it is entirely possible to make money on the raft of (to put it in a mild way) lower quality companies on the market ? especially in the small cap arena where sentiment can often come before fundamentals.
But for those investors who are interested in making steady and relatively predictable long-term returns, the quality investing approach is definitely one worth following.
Conclusion
Quality Investing is a quality book of which I have no real criticisms. The only real downsides (and they are small) is that it mainly focusses on larger stocks and probably won't be much use to day traders who look to profit on short-term, sentiment driven share price movements. In addition, the book is mainly focussed on analysing larger European companies ? bluechip stocks which have built up their businesses to a certain level but could still go further.
While the philosophies covered can also be applied to small cap stocks the book's focus is aimed at relatively low risk investors who want to make annual gains in the high single-digit range, as opposed to those who want to find stocks with the potential to make more short-term, multi-bagging returns. But that is by no means a bad thing ? as we all know small cap stocks can lose a large chunk of their value over a very short period of time.
Overall, for anyone new to investment this book is a great introduction to the industry, as it identifies how investors can pick out generally low risk companies which have the potential to generate decent compound returns over the long term. It is also an ideal complement to the knowledge of seasoned retail punters and finance professionals alike.
