Demystifying 'quality'

Demystifying 'quality' when picking stocks for portfolio in 2020

“Quality” is something which has not been defined by anyone. At one end, there is quality and at the opposite end, there has to be non-quality or junk.

There is a lot of discussion on what happens when you buy quality but much less on what happens when you buy junk. Is investing in junk really an option for the long term? Similarly, much is talked about on buying quality but not enough is said on buying false starts.

Is quality quantitative or qualitative?

Market participants will agree that high return ratios, positive free and operating cash flows, no leverage and no pledge—these are the things that make quality, parameters one can easily check but it is only partly true.

We think it is not only about these financial metrics; quality encompasses a much larger embodiment that includes various other parameters.

While corporate governance has been a trending topic, other factors that merit attention include the culture of the company; alignment of culture with strategy; management integrity, thought leadership and track record of execution.

Apart from that, investors should monitor discipline, fairness, transparency, and disclosures by the management; reliability of guidance and the conduct they have in their businesses. These are softer qualitative aspects that also go into defining quality.

Is the quality of growth and earnings relevant?

Quality is normally assumed to be of either business or the management. Also, the quality of growth is also important.

One should assess whether companies have cyclical businesses or structural and secular growth businesses and whether they have volatile earnings or consistent and stable earnings.

A long runway where competitive moats have an increasing trajectory offers longevity of growth. Capital efficiency in business and prudent capital allocation will ensure sustainable growth. Earnings beat and surprises compared to consensus estimates will lead to valuations automatically coming down.

Is quality external or internal?

A lot of discussion takes place on macros and betting on things that are not in our control, whereas a good part of quality incidentally happens to be internal, inward-looking and company-specific.

When we invest in companies with growth and quality together, there could be points of time when growth could be low due to a tighter external environment. But, once the external environment eases, or these companies take their own internal steps to counter it, the returns usually compensate for the lost period.

Is the margin of safety present in quality?

It has always been perceived that price is a measure of valuation and margin of safety is measured by the price we pay and the value we get. If one pays a low price, it means you get value and there is a margin of safety.

We believe that investing in quality itself is a big margin of safety. If one invests in quality stocks, the risk of permanent loss of capital reduces significantly which offers a margin of safety.

Is high PE (price/earnings) a symbol of quality?

Whenever there is a discussion about high PE and quality, it gets co-mingled. It is not necessary that quality has to be high PE or that high PE has to be quality. That correlation should not be made causation.

Are positive returns an indicator of quality?

It is convenient to presume that companies whose stock prices went up in the last one year are quality companies. This is not the case. Quality is measured by the strength in fundamentals of a company and not by the recent price rise.

Can growth vs value be replaced by quality vs value?

Among the various styles of investing, growth vs value has been among the most discussed one. The narrative has recently shifted to the quality vs value. Historically, its either growth or value, one of the two styles perform. Quality, in our view, should be taken as non-negotiable in either.

Growth correction or quality consolidation?

Value is dependent on earnings growth we get in the future, over the next few years. If a company estimated to grow profits at 20% delivers flat or negative growth, then it’s a risk because along with earnings, valuation multiples will also go down.

On the other hand, quality stocks normally face time consolidation which is not as worrying as growth correction in most of the cases.

Is growth expensive or is quality expensive?

In a growth starved environment, growth stocks will obviously get a premium. It’s important to dissect whether its growth stocks or is it quality stocks which are trading at premium valuations.

In most of the cases, it is those companies that have a steady combination of both, and attributing it to only one of the two is erroneous.