Quality investing is a way to pinpoint the specific traits, aptitudes and patterns that increase the probability of a particular company prospering over time – as well as those that decrease such chances.
In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.
A simple example illustrates their power. Say a company generates free cash flow of $100 million annually. Its return on invested capital is 20% and it has ample opportunity to reinvest all cash in expansion at the same rate. Sustained for ten years, this cycle of cash generation and reinvestment would drive a greater than six-fold increase in free cash. Albert Einstein famously referred to compound interest as the eighth wonder of the world. Compound growth in cash flow can be equally miraculous. The profound point is that the critical link between growth and value creation is the return on incremental capital. Since share prices tend to follow earnings over the long term, the more capital that can be deployed at high rates of return to drive greater earnings growth, the more valuable a company becomes. Warren Buffett summarized the point best: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” The best investments, in other words, combine strong growth with high returns on capital.
It is relatively easy to identify a company that generates high returns on capital or which has delivered strong historical growth – there are plenty of screening tools which make this possible. The more challenging analytical endeavor is assessing the characteristics that combine to enable and sustain these appealing financial outputs.
Above all, the structure of a company’s industry is critical to its potential as a quality investment: even the best-run company in an over-supplied, price-deflationary industry is unlikely to warrant consideration. On top of this, there are bottom-up, company-specific factors that must be understood. In combination with attractive industry structures, these form the building blocks which can enable a company to deliver sustained operational outperformance and attractive long-term earnings growth.