What's High Quality?
One of the most common questions I get is what do I mean by high-quality?
In the book, Zen and the Art of Motorcycle Maintainance the author tries to figure out what quality really means. How do you know the difference between a bad poem and a good poem? Is it the rhythm that makes it high quality? The complex vocabulary? Most likely, you will say that it's the combination of many factors and that's how it is with high-quality companies too. It's not just about a wide Moat a great brand, a strong track record, and a visionary CEO. It's the total package and in this post, I'll show you what I mean by high quality.
The Four Factors I Look For
Profitability
Management
Financials / Debt
Dividend Growth
Enduring Competitive Advantages
By enduring competitive advantages, I mean either a wide or a narrow Moat. Buffet uses the word economic Moat and explains that a company can have different kinds of Moats
Brand Moat such as Apple making them able to charge 15 % higher per phone even though the software is pretty much the same
Switching Costs such as Microsoft where so many companies have the Microsoft Package that it’s almost impossible to go to something else or at least the struggle isn’t worth it unless there’s a product which totally disrupts the business.
Establishing Costs such as AT&T or Dominion Energy where the cost of building the infrastructure needed to operate is so high that it’s basically impossible to enter the segment.
Patents such as J&J where they have the only permission to sell a drug, causing them to have a short-term monopoly.
A great way to see if a company has any kind of moat is to look at the return of equity (ROE). Imagine that someone opened a store selling hot-dogs and you can get a 30% return on your invested capital. In just a couple of years, you would have doubled your money and each year you'd earn more and more. Surely someone else would find a way to sell hot-dogs, causing prices to drop. New companies would start to compete and the new mission would be to try to find the perfect balance between price and quantity.
But if a company can operate for a long time without having any significant competition, we might be talking about a company with a strong moat. An example would be my favorite company, namely Rollins (ROL). For decades they have been able to maintain an ROE close to 30%. Btw, Rollins is the first company I’m going to buy in a recession.
Long Operating History
By long operating history, I want to able to check that the management has shown great leadership in depressed times as well as times with high growth (like now). I want to know that they have been smart with their money and invested in a proper way. As for management, I check that the Return on Invested Capital (ROIC) has been high for a long time. If it turns out the ROIC has been high for a long time, it shows that the management can find ways to inject capital and earn more money/profits. Again, if we use Rollins they have had ROIC above 40% since 2008. Simply astonishing.
Shareholder-Aligned Management
By shareholder-aligned management, I mean that I want the company to pay respect to me as a shareholder. In many ways, this is where most dividend investors fail. They think that management should pay a dividend no matter what, and they also want it to be as high as possible. Probably, many would prefer a two-digit yield. The problem is that a dividend payment isn’t something magical. A company can choose to spend the capital from the positive revenue on new assets such as machines, creating even grander growth in the future. They can choose to reduce debt which might not be a bad idea in a super low-interest-rate environment. Lastly, they can choose to pay a dividend to shareholders.
For stocks such as AT&T, where the market is very saturated and there aren't many ways to grow, I want to have a high dividend as my return for taking a risk in this company instead of just owning a bond or placing my money on a saving account. For REITs, it’s quite different since they are by law forced to pay most of their earnings as a dividend to shareholders. Still, I want to see that the company doesn’t have to increase debt in order to pay me. That might be sweet in the short-term, but it will surely end up bad. For stocks such as Visa, Medtronic or Hormel, I want a combination of high debt control, yield above or close to inflation as well as investment in growth opportunities.
So, in total I want management to be risk-averse, not paying me a dividend just because people want them to pay. In the USA, they operate with dividend aristocrats and dividend kings. Sure, many of these companies are great, but one needs to notice and be aware that they have a high pressure of not freezing the dividend or cutting the dividend. Many people invest in those lists without having a clue what the company does and demand money even though the company would be better of holding the dividend payment for a while.
As for reasonable payout ratios, consistent free cash flow and healthy balance sheet, I normally aim at a payout ratio for American firms at a maximum of 70%. For REITs, I look at the industry standard and the sector standard, but I’m not too eager when I see payout ratios above 100%. Since the free cash flow is in some ways the tool for a company to operate smoothly, being able to grow, invest and pay dividends, I want this to grow over time. Nothing is better than a consistent free cash flow year over year. It basically means that they get more and more money after paying their expenses to increase shareholder value.
As for balance sheets, I'm mostly focused on short-term debt, not that much on long-term debt. Debt is necessary to grow, but not being able to pay the short-term debt is dangerous. Here I want to focus on the current ratio, which is the total assets divided by liabilities to be above or close to 1. A current ratio of less than 1 means the company might find other ways to raise money to pay the debt.
When I have a general idea of how the company might be, I go on to the Stockles Risk Rating
The Stockles Risk Rating is created with the purpose of getting to know the business. I think that the best way to stay rational and calm in a stressful market is to know what you own and know what its good for. This Risk Rating is not absolute and a company can fit my portfolio even if a few questions are negative. I do this Risk Rating every time I buy stock in a new company to make sure I know what this partnership truly means.
About the Company
1. Geopolitical Risk: Is this company free of meaningful geopolitical risk? 2. Market Cap: Is the market cap greater than $1 billion? 3. Repeat Business: Does the business have high repeat customer usage? 4. Brand 1: Does the company have brand strength with passionate advocates? 5. Brand 2: Does the company's business rely on recognizable branding truly valued by its buyer base? 6. Safety: Is the safety score from SSD more than 75? 7. Growth: Is the growth score from SSD more than 75? 8. Yield: Is the yield score from SSD more than 75? 9. Is the company recession-proof?
Financials
10. Does the company have a good recent record of revenue growth? (Revenue CAGR) 11. Growth: Did the company increase its sales by 10% to 40% annually in the previous three years? 12. Profitability: Was the company profitable during the past year? 13. Consistency: Has this company shown consistent profits each of the last five years? 14. Cash Flow: Was the company cash-flow positive for the previous quarter, the last 12 months? Two of the last three years? 15. Diversification: Is the company free of any customer or supplier that accounts for more than 10% of sales? 16. Independence: Can the company execute its business plan without relying on external funding? 17. Leverage: Is the company's debt-to-equity ratio less than 1.0? 18. Current Ratio: Is the current ratio more than 1.0? 19. Net debt / EBIT: Is the net debt / EBIT lower than 2.0? 20. Financial Transparency: Are the financials easy to understand? 21. Return on Equity: Is the ROE/ROIC greater than 12% each year for the past five years?
Dividend
22. Yield: Does the company yield more than inflation? 23. Dividend CAGR: Is the CAGR more than 5% 24. Payout Ratio: Is the payout ratio less than 70%? 25. Dividend status: Is the company a king, aristocrat, contender...?
The Competition
26. Underdog: Is it free from stronger competitors? 27. Goliath: Is it free from disruptive upstarts? 28. Moat: Are there signs of a strong competitive advantage? 29. Is the company likely to avoid disruption and see most of its key markets continue? 30. Is the company Amazon Proof?
The Stock
31. Market cap: Does the stock have a market cap of more than $750 million? 32. Beta: Is this stock's beta less than 1.3 for the past 12 months? 33. P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30? 34. Forward P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30? 35. P/B ratio (financials): Does the stock have a price-to-book multiple around 1? 36. Forward P/B ratio: Does the stock have a price-to-book multiple around 1? 37. P/S ratio (growth): Does the stock have a price-to-sales multiple around 1 - 2 or less than 1? 38. Forward P/S ratio (growth): Does the stock have a price-to-sales multiple around 1 - 2 or less than 1?
Management
39. Insider Stake: Do founders and top executives have at least a 5% stake in the company? 40. Management: Is management trustworthy? (Do as they say and ROIC?)
What do you think? What's your definition of high quality? Please do tell.
Until then, take care
Stockles