In search for the quality in stocks

day 21.05.2021 * Reading time: 10min.

 
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In search for the quality in stocks

 

Quality control is critical for correctly positioning in a crisis or recovery. There are several methods for identifying high quality, which may be found in a variety of sectors and industries, ranging from firms that are more sensitive to economic cycles to those that have profitable growth drivers. Solid financial sheets, high and consistent profitability, and significant free cash flows are all positive indicators. In the pursuit of quality, active equity techniques have advantages. Passive methods describe quality using many metrics, but they are backward looking. Some firms that had previously performed well on quality metrics such as profits growth and profitability were put under strain during the coronavirus recession, as severe demand destruction manifested in unanticipated ways. This was mainly reported for businesses that had been fairly reliant on on-site, human interaction. And as the restoration progresses, the quality may exist in organizations that have rapidly and efficiently adjusted to an evolving post-pandemic environment.

While studying industry, demand – supply drivers and business models, investors can search for the quality by analyzing some critical areas in companies:

  • Solid Free Cash Flow– well managed organizations produce overabundance cash, which gives the flexibility and possibilities to generate above average returns;
  • Stable Profitability– a sign that a company has a differentiated and durable pipeline that can do well through changing environment;
  • Healthy Balance Sheets– companies with ample cash and low debt levels have more possibilities to invest and execute strategy.

The above mentioned criteria are interconnected. For example, the solid cash flow gives an opportunity to service the debt and maintain the balance sheet strong. Stable profitability and low earnings volatility might suggest the company manages well through changing environment and business conditions. Companies that represent all the three above mentioned features offer much more possibilities as far as the flexibility, market position, market-stress navigation and opportunities that appear during the crisis are concerned. It’s time to focus on the most important components that make up the concept of a quality company: innovation edge, dominant market position, company’s destiny navigation, professionalism of the management team.

Innovation Edge – better then the competition’s products, superior sale and internal process execution, strong leadership, deep pipeline, technology and information systems that allow companies to take advantage on the massive data and customer behavior, innovation that supports pricing power.

Dominant market position – wide competitive moats and high barriers to entry, any threats from the alternative supply source and/or technology, changing consumer behavior and corporate business model and corresponding risks, flexibility in market changing conditions.

Company’s destiny navigation – strategic and creative leadership, low regulatory risk, solid balance sheet and cash flow, low customer concentration, volume growth drivers.

Professionalism of the management team – sound leadership aligned with the long term value creation, insight leadership that makes the difference between the lag and lead in the critical situations, strong cultural health, commitment and development.

Let’s take a look at industries that seem to be interesting in the coming years, offering possibilities of above-average rates of return:

Chart: Technologies that offer quality opportunities – projected annual compound growth rate (%)

Past performance does not guarantee future results. US GDP estimate as of March 31,2021. Wind capacity 2019-2025; digital payments 2020-2024; DNA sequencing 2020-2023; internet traffic 2015-2020; digital health data 2018-2025; and battery electric vehicle units 2020-2025. As of March 31, 2021
Source: BCC Research, Cisco Systems, Global Wind Energy Council, International Data Corporation, Morgan Stanley, Statista

As supplementary tools for the quality stock analysis applied, we propose to use the company’s earnings analysis (companies with growing earnings + 10% and more annually in the longer term are an interesting investment target and rather rare) and the analysis of the return on assets (ROA), i.e. the profit generated by unit of the company’s assets and the rate of return on invested capital ROIC versus its weighted average cost of capital (WACC), which will determine whether the company is generating or absorbing cash.

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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The views expressed in this document do not constitute research, are not investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.