For investors looking to assemble a group of lasting, high-achieving businesses, the quality investing method provides a structured system. This approach centers on finding firms with durable competitive strengths, sound financial condition, and the capacity to produce steady, high returns on capital over many years. Instead of pursuing low prices or temporary fads, quality investors intend to be long-term holders of outstanding companies. One organized method to discover these firms is by using a stock screener based on measurable quality factors, such as the "Caviar Cruise" screen, which selects for solid revenue and profit increase, high returns on invested capital, strong free cash flow generation, and a reasonable debt level.
A recent prospect found through this screening method is Paycom Software Inc (NYSE:PAYC), a supplier of cloud-based human capital management (HCM) software. The company's financial characteristics seem to match the central principles of quality investing, making it an interesting prospect for more examination.
Matching the Central Quality Filters
The Caviar Cruise screen uses a number of strict financial tests to find quality prospects. Paycom's basic financial data indicates it meets these tests well, as shown by the detailed numbers given.
- Revenue & Profit Increase: The screen demands a minimum 5% compound annual growth rate (CAGR) for both revenue and EBIT (earnings before interest and taxes) over five years. Paycom surpasses this clearly, with a revenue CAGR of 7.1% and a notable EBIT CAGR of 22.9%. A central quality sign is EBIT increase exceeding revenue increase, which points to better operational efficiency and pricing ability. Paycom's major margin improvement, where EBIT increase is more than three times its revenue increase, is a positive indicator.
- High Return on Capital: A fundamental part of quality investing is a high return on invested capital (ROIC), showing a company's skill in profitably reinvesting its earnings. The screen selects for an ROIC (excluding cash, goodwill, and intangibles) over 15%. Paycom's number of 24.6% puts it clearly in the high range, showing it produces significant profit from each dollar put into its business.
- Financial Soundness & Cash Flow Character: The method stresses financial durability by requiring a Debt-to-Free Cash Flow ratio under 5. Paycom's ratio is 0.0, showing a balance sheet with no debt, an uncommon and solid position. Also, the screen checks for high "profit quality," calculated as the 5-year average translation of net income into free cash flow. Paycom's result of 84.8% is above the 75% minimum, showing its accounting profits are regularly supported by actual cash production, a mark of financial soundness and development.
A Broad Fundamental Perspective
An inspection of Paycom's wider fundamental analysis report supports the image shown by the screen. The company receives a total rating of 7 out of 10, with special performance in two areas important for quality investors: profitability and financial condition.
- Notable Profitability: Paycom's profitability score is a high 9 out of 10. It has industry-leading margins, with a gross margin above 82% and an operating margin around 28%. Its return on equity and return on assets are also much higher than industry norms. This steady high profitability is a characteristic of a company with a lasting competitive advantage.
- Excellent Financial Condition: With a health score of 8 out of 10, Paycom's balance sheet is a major strength. The lack of debt gives great operational freedom and avoids risk linked to interest rate changes or borrowing. While its current and quick ratios are moderate, its perfect solvency numbers and high profitability reduce common liquidity worries.
- Increase and Valuation Setting: The company displays a solid history of increase, though analyst forecasts suggest a slowing rate in the near future. Its valuation shows a varied image: while its P/E ratio seems high alone, it is actually lower than many industry competitors and the wider S&P 500. For a quality investor, paying a fair, not necessarily the cheapest, price for a better business is often suitable.
Why This Matches Quality Investing
The link between Paycom's numbers and the thinking of quality investing is evident. The high and rising ROIC suggests the company has a lasting competitive edge, probably through its single-database software platform that creates significant switching costs for customers. The debt-free balance sheet and very good cash flow generation provide the stability and financial means to endure economic slowdowns and fund future increase without dilution or financial pressure. These are exactly the features a buy-and-hold investor wants: a capably run company in a growing market (cloud HCM) that effectively compounds capital over time.
Finding More Quality Prospects
Paycom Software acts as a leading example of the kind of company a systematic quality screen can find. Investors curious about locating other businesses that satisfy similar strict financial tests can view the present results of the Caviar Cruise screen here.
Disclaimer: This article is for informational purposes only and does not constitute financial advice, a recommendation, or an offer to buy or sell any security. Investing involves risk, including the potential loss of principal. Readers should conduct their own thorough research and consider their individual financial circumstances and risk tolerance before making any investment decisions.
