Quality Stocks

While you may define a share as expensive or inexpensive, this must be done with respect to the company’s business concept. This is where the concept of quality, a factor that Warren Buffet constantly mentions, comes into the picture.

According to Buffet, you must only invest in businesses, where you want to be the owner of the business itself. If the business concept is good, the stock prices will reflect it at some stage. The easiest way to assess the quality of a stock is to look at the return on invested capital (ROIC).

The most common method of calculating capital is to deduct current liabilities from the assets (current liabilities are deducted from total assets). Another measurement method is Return On Capital Employed (ROCE), however, it is almost the same as ROIC.

Return On Equity (ROE) is slightly different from these two. It is the net result after the division of costs by the company’s equity. However, the issue with this method is that many companies have very little equity, some even have negative equity, as for example Philip Morris has had many times. ROE doesn’t consider the capital used for operations, thereby, giving ROIC and ROCE the upper hand over ROE.

A high ROIC would be preferable where there are equal investment opportunities. If two shares possess approximately the same assets but have varying ROICs, it means that the company with the higher ROIC is more attractive than the one with the lower ROIC, given their price is equal.

While there is no definite answer to what is good and bad ROIC, stocks with a higher ROIC than their competitors year on year are likely to have a lasting advantage.

MSCI, which was previously part of the investment bank Morgan Stanley, creates indices called MSCI Quality Indices. It looks at the following three factors to assess quality:

1. Return on Equity (ROE)
2. Debt Ratio
3. Variation/ Volatility in earnings per share over the past five years

The following figure shows that their Quality Index has performed better than the U.S. market (the market is represented by MSCI USA index- a mix of large-and-mid-cap):

The following figure shows the same trend across the world.

S&P has also created several quality indices and the following table shows the results over the previous decade.

 

Index	Annual Returns Over The Last 10 Years (As of April 2017)
S&P 500	5,46%
S&P 500 Quality	7,74%
S&P 500 Quality – lowest quintile index	2,79%

 

S&P’s indices are based on the same basis as that of MSCI. The S&P result indicates that there is a huge difference in the return on the best and worst companies even without looking at the valuation.

How investments can be made practically and quantitatively can be illustrated by the Indian management company Multi-Act. They’ve made an interesting analysis of how they invest in quality stocks. They use the following method to select their quality stocks based on a quantitative method:

1. Shares that offer a high return on equity are assumed to have a competitive advantage.
2. The accounts can be manipulated, therefore, a filter is used that looks at free cash flow per share divided by earnings per share. These two figures should be more or less the same unless there is an increased risk of accounting manipulation.
3. To ensure financial security, a measure of net debt and free cash flow is included- the number of years that the cash flow spends on repaying all debt.

This quantitative approach was used to test return in emerging markets, where they ranked the 500 largest companies and rebalanced the portfolio each year to include the 50 best companies based on the above ranking. The return between 2005-2015 was as follows.

The quality shares delivered almost twice the returns compared to the market at the time when price changes were much smaller. Even with price corrections, the quality shares fell only about 50%-60% of the fall in the index.

The quality factor has worked well in smaller niche markets as well:

Students John Inge Seljehaug and Morten Sandtveit wrote a master’s thesis in 2016 called Quality minus junk – An empirical analysis of quality investment on the Oslo Stock Exchange.

They defined Quality as profitability, growth, security (debt), and payment (shareholder friendliness). The shares were divided into quintile portfolios and rebalanced every month and market-weighted from 1993 to 2013:

It is clear from the above figure that K5 are the ones with the highest quality. As we see, it is only after the year 2000 that this strategy has given excess returns in relation to the worst quality shares (K1), and it really took off after the 2008-09 financial crisis.

Nevertheless, the students conclude that quality has only a limited explanatory effect on the Oslo Stock Exchange.