Features | Education | 6 Mins Read | by AG Latto
Quality investing is in vogue. But quality is often in the eye of the beholder. It is helpful to use a process to evaluate both quality and growth.
My article in July's issue of Master Investor seeks to do just that. 
PDF Article Download - What is Quality Investing?
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The first criteria for quality is that a business needs to be durable. It is no use investing in something that won't stand the test of time.
The durability of a business is open to debate. It depends on whether key risk factors come to the fore, with the tobacco sector a case in point.
If a business is deemed to be durable we can turn to the financial criteria.
To compound value for investors a business needs to 1) generate high returns, 2) sustain high returns and 3) realize high-return growth.
The combination of high-returns and high-return growth generates free cash flow growth. Companies are valued according to the free cash flow they will generate.
As a reminder, free cash flow is the surplus cash that can be distributed to investors. The more free cash flow a business can generate, the greater its value.
Quality companies with the scope to grow merit a higher valuation than other businesses. This is because they have the scope to generate and grow free cash flow.
I have labelled quality companies with the scope to realize high-return growth as stock compounders. An earlier article explains the concept in more depth.
Diageo provides a good example. The group has been durable and generated strong free cash flow growth. This has resulted in the share price performing well.
Diageo free cash flow growth: the trend is your friend
Source: SharePad
Diageo share price
Source: SharePad
BME case study
Quality by itself is no guarantee that investors will generate a good return. Without the ability to invest in high-return growth, a business won't be able to increase free cash flow over time.
A good example is the Spanish exchange group Bolsas Y Mercados Espanoles (BME). The vast majority of profits have been returned to investors by way of dividends.
BME has little scope to reinvest in growth. The result has been no free cash flow growth and a share price that has gone sideways since its IPO in 2011.
BME is a business that is very profitable in terms of the operating margin and the return on capital. However, the group doesn't have the scope to realize high-return growth.
The total return for BME shareholders may still have been reasonable on account of dividend distributions.
But a firm that cannot grow free cash flow is similar to a high-quality bond. It won't benefit from the advantage of equities over other assets classes - the ability to reinvest at a high rate of return.
Equities have more scope to compound value than every other asset class. This is on account of their scope to reinvest at a high rate of return. Not other asset class can do this (See Terry Smith article here).
BME free cash flow per share
Source: SharePad
BME share price
Source: SharePad
Valuation
It should go without saying that valuation is important. It is an issue that often leaves investors hot under the collar.
It is easy to overpay, as we have recently seen with regard to Craneware. The group was trading at over 50X trailing earnings before it issued a disappointing update.
Craneware P/E based on trailing 12 month earnings
Source: SharePad
Craneware share price
Source: SharePad
The bottom line is that we want to buy into companies that will do well over the long-term. From a financial perspective this means the ability to generate free cash flow growth. We also want to buy them at an attractive price.
Valuation is important. But our first priority, in my view, should be to buy companies that will do well over the long-term.
The alternative is to buy companies that are unlikely to do well over the long-term. This is an approach that is much harder to make work and which has much more blow-up risk.
Contrarian and value investors focus on buying companies that are 'cheap.' However, they are all too often cheap for a reason.
Value and growth investing
The traditional styles of investing are value and growth. Value focuses on companies that are inexpensively priced relative to current valuation multiples.
Growth investors are willing to pay a premium valuation for companies that have potential. These are firms that are growing fast today or have the scope to deliver rapid growth at some point.
The problem is that the growth style and the value investing style say nothing about quality. But quality is critical in both preserving value and in the ability to compound value.
The growth style of investing did well in the 1990's during the dot com boom. It then did very poorly in the follow years as the boom turned to bust.
The value style did poorly in the 1990's and then came into its own in the subsequent years. However, the value style of investing has underperformed growth for the last 10 years.
Russell 1000 Growth ETF versus the Value ETF
Source: SharePad
What does all of this mean? A stock isn't necessarily good because it is a growth stock or a value stock. These are blunt instruments for choosing where to invest.
Shares tend to perform well if the underlying companies can generate free cash flow growth. Quality companies with the scope to realize high-return growth are able to do this.
Will the quality style go out of fashion?
Growth and value investing go in and out of fashion. This is because one of the styles can deliver for a long stretch before the other style takes over.
It is therefore easy to view quality investing in the same way: an investment style that delivers the goods for a certain period before coming up short.
It is certainly possible for quality companies to become over priced. This will dampen future returns.
The most prominent example is the Nifty Fifty stocks on the NYSE in the 1960s and 1970s. They performed exceptionally with investors ignoring valuation metrics.
Many Nifty Fifty stocks had price to earnings ratios at around 50X.
However, the 1973-74 market crash saw the Nifty Fifty underperform the market on the downside. The quality of the Nifty Fifty companies didn't save investors from relatively poor returns.
So it is certainly possible for quality companies to be over priced. However, quality businesses should still continue to deliver over the long-term.
Quality businesses have seen their valuations increase in the last decade. But they are not close to the 50X ratio afforded to Nifty Fifty stocks.
In my view, quality is the key component to both preserve value and compound value. It is not something that can 'go out of fashion' in the same way that growth or value investing can. But we do need to be careful to not overpay.
If we use Diageo as an example the spirit makers P/E based on last 12-month reported earnings has increased. But the forecast for the current fiscal year to June 2020 is not excessive at 25X.
Diageo's valuation doesn't appear to be excessive
Source: SharePad
Summary
Investors want to compound value over the long-term. The easiest way to do this is to invest in companies that compound value over the long-term.
Quality companies with the scope to realize high-return growth are able to compound value. They benefit from the unique advantage of equities - the ability to reinvest at a high rate of return.