Quality investing strategies are simple to execute in the complex world of investing.
When focusing on quality, fund managers keep their eye on the top prize by setting out to purchase financially fit companies with strong earnings and stable balance sheets. This means a solid track record of capital efficiency.
Definitions of what it takes to make a quality company varies, though they are largely associated with competitiveness, efficiency, financial stability and a healthy return on equity.
Quality investing is a longstanding strategy in the investment world that has never gone out of style. In fact, investing in quality companies is an approach that can be traced right back to economist and mentor to Warren Buffet, Benjamin Graham.
In the investment world, constructing a quality portfolio means comparing quality characteristics of a company relative to its peers in the same sector. There may also be a need to implement a constraint on sectors that have an element of risk, perhaps due to economic constraints.
Financially sound companies with a long history of solid earnings can be hard to come by. Most companies run into financial trouble at some point, but investors focused on quality investing give them a wide berth.
That’s according to the founder of Sydney’s Arch Capital, Nigel Baker, who says that investing relies on process and discipline.
While its critical to use managers that have a thoroughly researched and disciplined approach to ensure they carefully select companies they invest in, quality investing also comes down to excluding companies that don’t suit their remit, Baker says.
“Not all companies are profitable, which may defy logic given that’s the key of going into business,” Baker tells Professional Planner.
“When selecting a company with a track record of generating profits, investors ensure there’s sound management and effective controls in place.”
New management, for example, can come in and upset years of good management process. Consistency and a long track record of profitability is important to investors.
Only a strong balance sheet ensures investors have the asset backing for growth, but also to enable them to withstand any short-term pressures.
“Profitability is also a driver of returns,” Baker says.
“Firms with higher profitability have been shown to have higher returns in the future than those with lower profitability, so it can help enhance the prospects of overall greater returns.”
Saikal-Skea Independent Financial Advice founder Andrew Saikal-Skea says he prefers turning to ETFs as a means of filtering investment styles.
“Our primary use is a quality filter to reduce volatility for our retirees and more conservative clients,” Saikal-Skea says.
“Aside from being able to provide a smoother return and income profile, quality filters can help clients that have been used to holding individual equities feel more comfortable moving to a diversified ETF approach.”
In his book, The Intelligent Investor which was first published in 1949, Graham points out that investors should only invest in companies in a sufficiently sound financial position with the potential for earnings to be maintained over the years.
These companies, Graham wrote, show resilience by experiencing a market drop during periods of economic downturn less often, and also tend to recover much more quickly than other companies.
Everything else being equal, the lower the price relative to book value and the higher the expected profitability, the higher the expected return, he wrote.
“The key criteria include higher return in equity, lower leverage/low debt, stable earnings growth” Graham wrote.
“There are many profitability ratios investors may look at, as well as the growth profit margin, cash flow analysis, industry comparisons, their dividend pay out and yield and assess future growth prospects.”
