The easiest way to explain what quality investing exactly entails is to compare this form of investing with the typical value or growth investment.
Whereas the typical value investor looks for low valuation ratios in the hope of buying shares that are quoted well below their intrinsic value, the growth investor will rather focus on high turnover growth, even at the expense of profitability. People invest early in such growth companies in order to achieve very high returns in the near future. Examples of typical growth companies are Netflix (NFLX) and Domino's Pizza (DPZ), for example.
The danger, however, is that typical growth and value characteristics can be misleading. Low-rated stocks can still be expensive if the company in question has a poor outlook, and for growth stocks, only a very small percentage really grow into the mega-success stories that are widely known...
Those who invest in quality abandon that classic contradiction and focus first and foremost on 'good' companies. But what are "good companies"?
In any case, they are certainly companies with an excellent track record in terms of sales and profit growth and where profit margins are stable. This is usually accompanied by considerable brand power. A strong, high-quality product in conjunction with high brand recognition leads to consumer loyalty that should not be underestimated.
The debt burden is relatively low and if there is any debt at all it will be used exclusively for further growth. Debts that serve to overcome a difficult period or even to avoid imminent bankruptcy are obviously inadmissible when identifying quality companies.
Stable moderate dividend growth is key but do not expect (extremely) high dividend rates. As in many aspects, reaching the top is difficult but the real challenge is to maintain this position. Consequently, sufficient investments need to be made to maintain the often existing competitive advantage and to continue to innovate, both by improving existing products and bringing new ones to market.
The competitive advantage in question is better known as what is sometimes described as the 'moat'. A sustainable competitive advantage consists of being able to exploit the advantage over a long period of time so that it becomes very difficult for the competition to grab market share. The brand power mentioned earlier in this article is such a sustainable advantage that should not be underestimated. But it may well be purely a financial advantage as well. A large company with multiple sites and a global sales market will undoubtedly benefit from the scale advantages that help to keep costs in check. As a new player in the same industry or sector, you don't have those advantages and the profit margin quickly becomes (too) tight if you want to apply a competitive price.
Genuine quality companies have a rock-solid balance sheet (relatively low debt and plenty of cash) and can therefore withstand adverse market conditions.
Good companies need good managers and this is perhaps even more true for typical quality companies. A mediocre product can indeed grow into a success in the hands of experienced managers. An excellent product will rarely be a success without the right professional framework.
As far as this item is concerned, quality investing falls neatly within the boundaries of value and growth investing. Looking for really low valuations however is pointless if you really want to invest in quality companies. Quality has a price, but beware... Not everything that is expensive is necessarily a synonym for quality. That is at least as big a trap as the bargain hunter who buys purely because of a low P/E ratio but ends up with only those companies that nobody else wants....
Market sentiment does strange things to people and certainly to investors. Shares of new hip sounding companies which in no time see their market value increase tenfold or more without ever making a single cent in profit, they certainly exist! However, price is anything but the first criterion a quality investor considers. The fundamentals are the most important and if they are good, a quality investor will be willing to pay an acceptable premium without lapsing into excess.
A typical feature of fundamental investing is a sufficiently long investment horizon. This is certainly true in the case of quality investing which, in this sense, is very similar to the buy-and-hold approach. However, the quality investor is always on his guard and keeps a close eye on the quality foundations on which the company was built. If these start to crumble, the quality investor will, without a doubt, say goodbye to the company in question. The company should therefore continue to be monitored after the purchase, especially if potential competitors gain more ground, it is important to keep a finger on the pulse.
Quality investors should be particularly interested in innovation, especially if that innovation has a significant impact on the activities of the quality companies in which they invest. If the company in which you invest is one of the driving forces behind that innovation, that is certainly a major advantage. Years of experience in the sector or industry give them an edge.
A striking example of new developments is the way in which we watch films and series or listen to music these days. The once so successful music and video stores have rapidly disappeared in favor of the exponentially growing streaming services.
In a subsequent article, we will take a closer look at the typical financial ratios that can be used to arrive at a basic selection of quality stocks.