Quality Investing is an investment strategy and philosophy that aims to identify the best quality companies and hold them for the long term. A quality investor seeks to purchase financially healthy companies that have a strong track record of success, high earnings, and a market-leading position with a competitive edge. These high-quality companies often reflect dedicated management with excellent capital allocation skills, enabling them to achieve high returns on capital and equity over extended time horizons.

TABLE OF CONTENTS:

What is a Quality Investor?

Quality investing is not a widely discussed investment style compared to Growth or Value Investing. While it is an excellent strategy, it may not be suitable for everyone. The difficulty in implementing this style lies in the investor’s psychological makeup, as it requires a preference for simplicity over complexity, even though the strategy is successful.

Put together the compounding machines, and then do nothing.

Terry Smith

A Quality Investor focuses on companies that consistently deliver returns to shareholders and possess quality attributes that keep them fairly priced. These companies are also called “Compounding machines”, as they have a proven track record of compounding capital over a long-time horizon. Quality investing has outperformed the market for decades.

The quality investing strategy relies on both quantitative and qualitative fundamental criteria. Quality encompasses not only the company’s financial structure but also its management team. The goal is to find the absolute best company in its field, not just the best in class.

One of the key features of quality investing is taking advantage of compounding. Typically, a quality investor adopts a buy-and-hold strategy, allowing the company’s high returns on capital and the power of compounding to work wonders over time.

How does Quality investing work?

Quality Investing involves identifying companies that are efficient with their capital allocation and can reinvest free cash flow at high rates of return over decades to create serious wealth for shareholders. A Quality Investor believes in buying such companies and holding them for a long time to allow their capital to compound, similar to investing in a managed fund or an index fund.

Quality investors do not over-diversify in their holdings and focus on holding the very best quality companies, which can perform well during all market conditions. These companies usually have certain quality metrics like mission-critical software, or a strong brand pull like luxury high-end retailers, that continues to perform well.

Quality companies generate a lot of cash and reinvest it wisely to not only grow but also defend their competitive advantage, making quality investing a lower-risk way to invest in a variety of market conditions. This is what makes it such a great strategy you buy and hold the very best.

Most investors like the idea of buying high-quality shares that can generate reliable returns over a lifetime, with minimal involvement. The companies are usually profitable now, there is no waiting for a company’s future to play out, they often are already at the top or on their way to it. This leads these companies to rarely be undervalued.

How do Stocks enter a Quality stage?

A company becomes a “Quality” company due to possessing certain characteristics, which are usually evident early on. These companies are often characterized by strong fundamentals since their initial public offerings (IPOs). They become industry leaders, excelling in multiple ways compared to their peers. They often operate low capital-intensive businesses with high margins. Once a company has become profitable, it usually focuses on improving margins by taking advantage of operating leverage. As the company reaches the break-even point, it works on improving operations, and margins, and becoming a more sustainable cash machine.

Although these companies may have gone through hyper-growth stages, they still have long runways for growth. The quality factor comes into play as the company becomes more profitable, generating a lot of free cash flow with a more efficient model. The key is that this free cash flow can be reinvested back into the business at higher rates of return than the company’s cost of capital.

If a company can earn a high return on equity, with ample room to reinvest those earnings, this cycle creates compounding machines. These businesses can use their cash to widen their MOATs, reinvest in innovation, R&D, and continue to expand either organically or with strategic bolt-on acquisitions. As a result, they produce even more free cash flow.

Quality compounds are usually not small companies; they have been compounding and maximizing their unique business models for years, moving further away from their competitors and becoming harder to compete with. Competitive advantages, such as network effects, patents, strong branding, switching costs, or a sticky customer base, create these quality companies. The challenging barriers to competition allow the business to maintain high financial productivity longer than the market anticipates.

What are the Pros and Cons of being a Quality Investor?

The pros and cons relating to quality investing are not necessarily based on downside risk such as that may come with Value or Growth Investing. It is about the strategy itself, the approach needed to make it successful long term. Here are a few pointers to consider:

➕ PROS	➖ CONS
A great strategy to compound capital with minimal effort long-term. Buy right and monitor.	Requires a lot of patience, it is a buy-and-hold strategy. This may be hard for certain investors who like to tinker.
Highly profitable over a long time horizon as compounding works magic, especially at higher rates of return.	Requires discipline to stick to the strategy long term. Picking, filtering and buying the very best companies.
These quality companies are usually market leaders with a very strong MOAT carved out and make them hard to attack.	Quality companies rarely go on discounts, paying a fair price is important as they can be pumped up in times of euphoria.
Quality companies perform well during a variety of market conditions making them a good holding in a diverse portfolio.	Hard to evaluate a company’s competitive edge, this needs a deep understanding of the underlying business.
Less volatility as quality does not fluctuate like rubbish.	Usually requires some concentration as there are not many quality companies out there, and investors may need further diversification.

What are the Characteristics of a Quality stock?

Quality companies typically share similar characteristics. While many companies consistently make money, the difference with quality companies is that they consistently generate free cash flow, and they can continue to do so in the future. These types of companies have a proven track record of success.

Here are some of the key traits of quality companies:

• Market leaders and better than their peers.
• Strong financial position, including balance sheet strength, cash flow, and assets.
• Usually possess a very strong competitive advantage, often referred to as a MOAT.
• They have efficient business models, which are robust, have low capital expenditures, and are maximized for operating leverage.
• Exhibit consistent earnings growth.
• Higher than average Return-on-Equity (>20%).
• Higher than average Return-on-Capital (>20%).
• Historically, they have shown Compounding Annual Growth Rates (CAGR) of over 15%.
• They have years of performance supported by a lot of data.
• Low leverage and Debt-to-Equity ratios.
• Generate reliable profits and are free cash flow positive.
• High barriers to entry and competition.
• Long-standing management with a track record and alignment with shareholders.
• Diligent capital allocation towards R&D, Marketing and innovation.
• ESG (Environmentally Sustainable and Governance) focused.

How to consider the Quality investor approach in your Philosophy?

Quality investing is a strategy that may not be suitable for everyone. Before implementing this approach, investors must realize that they require the correct mindset, time-frame, and knowledge to be successful.

Patience is essential because this strategy involves leaving your capital to compound over a long period. If you need the money in the short-term, this strategy won’t take advantage of the effects of compounding.

Investors should own a concentrated portfolio of high-quality businesses that can deliver strong organic growth even if the economy falters.

Michael Burry

Although these quality companies are leaders in their field, it does not mean they are invincible to market fluctuations. Hence, you need to have the conviction to hold them even during panic sell-offs.

Having a deep underlying knowledge of each company can help. Monitoring these businesses and looking for disruption in the competitive advantage, reduction in earnings, or a decline in market share and returns on capital can ring alarm bells.

Finding these quality companies is challenging as there are not that many out there. Understanding how to research, evaluate, and what defines quality is crucial. You can’t rely on financial metrics alone; you need to study management, who is the capital allocator, how is the competitive edge refined, and what would hinder the company’s growth plans?

The quality investor is the one who has a long-time horizon, patient capital, and wants to own the very best quality companies they can buy. They trust the management to compound their capital for them. It is an excellent strategy for investors who want to be a little “lazy” like myself. Buy great companies and let them do the heavy lifting.

In Summary…

To become a successful quality investor, it is important to approach companies differently. Instead of just focusing on metrics and analysis like DCF models, valuation and price, it is important to think about what could potentially disrupt the company’s position at the top. Consider the business model and its longevity, and assess whether the company has a long runway for future growth.

Quality companies typically have opportunities to reinvest capital, which allows them to continue growing. Therefore, fundamental analysis is a unique tool when evaluating quality companies. It’s not just about finding a company with high ROE, FCF, and no debt, and calling it quality. One must consider whether the company’s business model can last and continue to compound for decades.

If you can buy a quality compounder at the right price and hold it, it can work wonders. As a GARP investor, I love quality and growth potential, but I am cautious not to overpay. Ultimately, price is essential when it comes to quality or most investments. A fair price is considered to be fair value or even undervalued because, from a long-term perspective, the price compared to the future free cash flow the company generates may seem minimal in comparison.

Buy-and-hold does NOT mean buy and do nothing or set and forget. NEVER FORGET, always monitor, all though I am a lazy investor I never buy companies and check in on them once a year. Always monitor your thesis and look for signs the company may be losing its edge. You don’t want to buy and hold a former glory as it enters a declining business cycle.