A key element of any investment philosophy is to invest in ‘quality’ companies. We believe quality companies deliver higher returns at a lower level of risk than low quality companies. The issue with the term ‘quality’ is defining what exactly is a quality company and what it’s not. Quality is a subjective measure and what may look like quality to one person is not to another. It is also difficult to measure and value. Unfortunately we cannot simply insert a line into a company’s balance sheet called ‘quality’ and attach an appropriate dollar figure.
Here are some key indicators of quality companies:
1. Track record of steady growth in earnings per share (EPS)
A quality company should be growing its earnings over time. It is important to look at EPS rather than just profits because profits can be inflated by issuance of additional equity and acquisitions. EPS is the best measure of real earnings growth.
2. Track record of steady growth in dividends per share
Nothing is more transparent than dividends. The payment of a dividend proves that a company has cash on hand and the financial muscle to produce a cash flow to shareholders. Dividend growth is the key to long-term share price performance
3. Strong balance sheet
It is a simple, but little considered, fact that companies with no debt do not go bankrupt. Some companies that have defensive businesses and high cash flows can tolerate higher levels of debt, but always look for rock solid finances, of which having a manageable level of debt is a key attribute.
4. Strong market position and pricing power
For share investors, competition is the enemy. Prefer companies that have the mettle on their competition either because they have an unrivalled brand, distribution network or product, or look for companies that face low levels of competition, like many utilities. Excessive competition puts pressure on margins and undermines profitability. Look for companies that have high levels of pricing power. Having the ability to increase prices is indicative of a company with a strong market position. Utilities sometimes have this pricing power controlled by regulation.
5. Inherently defensive business
Companies with businesses that are defensive are generally higher quality companies. Defensive businesses are those that provide goods and services for which there is a reliable and growing demand. Companies that provide these sort of ‘core’ services include, banks, utilities, oil companies, healthcare companies, and producers of food and personal hygiene products.
6. Strong management
The experience, vision, leadership skills and integrity of management can have a huge impact on the performance of a company.