Search the Internet for “measures of investment quality” and you are likely to find roughly one-tenth as many results as you would if you searched for “measures of investment return” or “measures of investment risk.” Quality, it seems, is hard to define.
Across the investment management industry, definitions differ. Here we summarise the five aspects of quality we consider most important when assessing companies for inclusion in a fund.
1) Business strategy and prospects
Before investing, we need to believe that a company’s business model is durable. We, therefore seek evidence of industry growth, a clear business strategy and solid execution of that strategy.
Some important questions include:
- Is the company overly reliant on acquisitions to sustain growth?
- Does the company have a distinct value proposition that gives it pricing power?
- Would we feel comfortable locking the stock in a box and not touching it for five years, or would we worry about its impact on the portfolio?
2) Industry traits
The industry in which a company operates is important. According to the Global Industry Classification Standard established by MSCI and Standard & Poor’s, there are 67 industries worldwide, ranging from aerospace and defence to wireless telecommunication services. Industry characteristics naturally vary. Some businesses are capital-intensive, while others are less so. Some are difficult to enter, while others have low “barriers to entry”.
Some important questions include:
- Has the rate of industry growth been consistent or uneven, and what are the industry’s prospects?
- What level of capital expenditure is required?
- Is the industry highly competitive and fragmented or dominated by a few companies?
3) Management team
The motivation, experience and track record of the executives atop a company are vital. We always ask ourselves if we trust the individuals in charge.
Some important questions include:
- Do they have the necessary backgrounds and capabilities to manage the business?
- Is it a one-person show, or does the company have a deep pool of management talent?
- Have they done a good job allocating capital?
4) Balance sheet
Most investment advice cautions you to do your homework first. But even if you’ve done your due diligence, companies don’t stay still. Some lose their way.
Corporate profit reports tend to capture financial news headlines, but we view the balance sheet as a better gauge of a company’s financial health. The balance sheet provides a snapshot of a company’s assets, liabilities and equity.
Interpreted properly, balance sheet data can reveal how much debt a company has, if customers are paying on time and whether the company is investing its surplus cash wisely or allowing too much to sit idle. As an investor, we feel much safer when a company offers a strong balance sheet.
A robust balance sheet usually means a firm has spare cash to fund corporate expansion or to boost shareholder returns via share buybacks and/or higher dividends.
Some important questions include:
- Is the business over-leveraged?
- How variable is the cost structure and thus profit margins?
- Does the business generate free cash flow during both good and bad times? (Free cash flow is the amount of cash a company has after expenses, debt service, capital expenditures and dividends.)
5) Commitment to shareholder value
For whom are companies run? In a public company the shareholders are the owners. When owners are passive shareholders and entrust management to outsiders, problems of agency may occur. The manager, possessing more information on the day-to-day business of the company, may try to maximize his wealth at the expense of the owner, creating a conflict of interest.
This conflict plays out all the time. CEOs leave office having earned millions despite an underperforming share price. In theory codes exist to determine “best practice” in governance. A standard recommendation is for a majority independent non-executive board of directors to oversee managers on behalf of shareholders. Good corporate governance boils down to a proper system of checks and balances and a more subtle thing: trust.
Some important questions include:
- Do independent board members have the power to influence the direction of the company?
- Are measures of executive performance aligned with the interests of long-term shareholders?
- Does the company have classes of stocks with different voting rights?
In conclusion
When markets fall, good stocks often go down with the bad. At Aberdeen, we focus on what makes a company good, then buy when the price is right. If a business is sound, you can ignore market noise, knowing patience can be your best friend.
Good companies have clear commitments to shareholder value, easy-to-understand business strategies, plainspoken and trustworthy management teams, strong balance sheets and proper board governance.
We also like companies with relatively predictable earnings — bearing in mind the inherent ups and downs of economies and sectors.
Not every company will score well on every measure of quality, and the weight we assign to each measure may differ from one industry and company to the next. This is where judgment counts.
Once we have identified a high-quality company, we can proceed to questions of valuation, recognizing that even the highest-quality business can make for a poor investment if it is overpriced at purchase.
But that is not the end of it. The investigation of quality continues after we’ve invested. The five aspects above exemplify how we ensure that our investments retain their quality. Especially in tough times.
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This article is brought to you by Aberdeen Asset Management.
