Quality investing
From Wikipedia, the free encyclopedia
Quality Investing is an investment strategy based on identifying investment vehicles with above-average quality characteristics.
The idea for Quality Investing originated in the bond and real estate world, where both the quality and price of potential investments are determined by ratings and expert attestations.
Where equities are concerned, fundamentals analysis and active stock picking are used to identify stocks whose quality is particularly outstanding when measured according to a variety of business variables and financial coefficients. What's more, Quality investors usually invest only in those Quality equities that are also attractively valued.
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[edit] History
The bond and real estate universes both have long traditions of classifying investment instruments according to their quality characteristics. Ratings for corporate and public sector bonds tell us something about the borrower's creditworthiness. They also distinguish clearly between two quality classes: "investment grade" and "speculative grade" (also known as "junk bonds"). Meanwhile, the quality of real estate is evaluated by experts, or "appraisers". Although there is no definition in law, quality in real estate terms is determined on the basis of a specific schedule of criteria. It is usually used to establish property values.
Benjamin Graham, the founding father of value investing, was the first to recognize the quality problem among equities back in the 1930s. Graham classified stocks as either Quality or Low Quality. He also observed that the greatest losses result not from buying Quality at an excessively high price, but from buying Low Quality at a price that seems good value.[1]
The Quality issue in a corporate context attracted particular attention in the management economics literature following the development of the BCG matrix in 1970. Using the two specific dimensions of life cycle and the experience curve concept, the matrix allocates a company's products – and even companies themselves – to one of two Quality classes (Cash Cows and Stars) or two Non-Quality classes (Question Marks and Dogs). Other important works on corporate business quality can be found primarily among the US management literature. These include, for example, "In Search of Excellence" by Thomas Peters and Robert Waterman, "Built to Last" by Jim Collins and Jerry Porras, and "Good to Great" by Jim Collins.
Quality Investing gained credence in particular after the stock market bubble of 2001 burst and investors learned of the spectacular failures of companies such as Enron, Worldcom and Parmalat. Balance sheet manipulation and other forms of financial fraud resulted in increased investor demand for the targeted selection of Quality stocks.
[edit] Identifying Quality Stocks
As a rule, systematic Quality investors identify Quality stocks using a defined schedule of criteria that they have generally developed themselves and revise continually. Selection criteria that demonstrably influence and/or explain a company's business success or otherwise can be broken down into five categories:[2]
1. Financial basis: A review of a company's financial basis centers on its balance sheet, as well as comparisons of financial coefficients with sector or market averages, or direct comparisons with other companies. These figures should not be viewed in isolation, but in the company's overall context. Particular attention should be paid to earnings, cash flow and free cash flow, as well as debt. Income streams must also be examined. The more income the company can generate with its core business, the better its quality tends to be.
2. Price potential: In Quality Investing, quality and attractive valuation are closely linked. While a rigorous quality filter may help to prevent share price losses when things are going badly for the company, factoring in an attractive valuation will ensure that the stock outperforms the market in the medium to long term. When assessing valuation, particular attention must be paid to discounted cash flow and the price/earnings and price/book ratios. Comparing these figures with the market averages gives a feel for a stock's relative valuation.
3. Business model: Analysing a company's business model should provide clues as to what strategy it pursues to serve what markets with what range of products or services. Competitive advantage, specifically, has an important role to play here. The business model must be comprehensible and must focus on core expertise while being sufficiently diversified. Business risk and business trends must be quantifiable, and it should be possible to estimate the business model's earnings potential.
4. Market environment: An analysis of market environment is an essential part of evaluating business model quality. A sector perspective is unwise, however. Quality companies must be able to stand their ground in a particular overall market, and should not be labeled "Quality" simply because they stand out in what may be a weak peer group. When analysing the market environment, the potential size of the market and the company's position within it play just as great a part as future market trends and the degree of competition. It is also important to know what level of profitability can be achieved in this market, as well as the capital intensity that must be expected.
5. Management: In most cases, a company is only as good as the people who manage it. Evaluating management is therefore important, but also relatively difficult. Indicators of good management might include low turnover rates, as stability — especially in the management team — is often a good sign. The company's management structure should also be clear and logical. Rapid management cycles, i.e. frequent Board and management meetings, may indicate good communications and efficient processes. The company should also have good relations with its shareholders. The quality of investor relations can provide clues here.
[edit] Quality vs. Value and Growth
Quality Investing is an investment style that can be viewed independent of value investing and Growth Investing. A Quality portfolio may therefore also contain Growth and Value stocks.
Nowadays, Value Investing is based first and foremost on stock valuation. Certain valuation coefficients, such as the price/earnings and price/book ratios, are key elements here. Value is defined either by valuation level relative to the overall market or to the sector, or as the opposite of Growth. An analysis of the company's fundamentals is therefore secondary. Consequently, a Value investor will buy a company's stock because he believes that it is undervalued and that the company is a good one. A Quality investor, meanwhile, will buy a company's stock because it is an excellent company that also happens to be attractively valued.
Modern Growth Investing centers primarily on Growth stocks. The investor's decision rests equally on experts' profit forecasts and the company's earnings per share. Only stocks that are believed to generate high future profits and a strong growth in earnings per share are admitted to a Growth investor's portfolio. The share price at which these anticipated profits are bought, and the fundamental basis for growth, are secondary considerations. Growth investors thus focus on stocks exhibiting strong earnings expansion and high profit expectations, regardless of their valuation. Quality investors, meanwhile, favor stocks whose high earnings growth is rooted in a sound fundamental basis and whose price is justified.
[edit] References
- ^ Graham (1949). The Intelligent Investor, New York: Collins. ISBN 0-06-055566-1.
- ^ Weckherlin, P. / Hepp, M.: Systematische Investments in Corporate Excellence, Verlag Neue Zürcher Zeitung. ISBN 3-03823-278-5.
