Why quality is your winning strategy

Australia’s top 10 and bottom 10 stocks by quality.

Summary: The key competitive edges investors can focus upon are a view on the business: its Quality and Value derived from a tested and rational approach. Just avoiding the poor businesses likely to stumble will greatly improve your chances of achieving above-average long-term performance.
Key take-out: Most investors focus their attention on earnings, when they are often best served bypassing the “Profit & Loss” account and focusing on the cash generating ability of the business. Even if a business is reporting accounting profits, it might be losing money on a cash basis.
Key beneficiaries: General investors. Category: Shares.
Most investors want to pick successful stocks, but they also want to know they are ‘quality’ stocks. They don’t want unpleasant surprises or unexpected dramas.

In searching for these prized assets, StocksInValue (a joint venture between Eureka Report and Clime) uses a new quality rating and we are happy to give Eureka subscribers a substantial ‘sneak peek’ at the service today.

David Walker of StockInValue (above on video) and George Whitehouse of Clime introduce this new approach to quality and very usefully reveal 10 top-quality stocks in our local market.

He also identifies the 10 lowest-scoring stocks on the quality criteria. As you will see below, the quality of stocks has little to do with their activity or their sector; rather, quality is found in individual company accounts presented by competent management. See the full tables showing the top 10 and bottom 10, ranked by quality.

The published accounts of a listed company remain our main window into any operation aligned with crucial variables such as the treatment of debt. Among the better stocks, we find some investor favourites such as real-estate group REA and fund managers Magellan and Platinum, but there are also lesser-known names such as perennial strong performers like auto accessories shop ARB and software services company Technology One. Among the poor performers are well-known miners such as Lynas Corp, but also high-profile groups such as toy retailer Funtastic.

All up, it’s a fascinating list which suggests every company must be taken on its merits and quality – or the lack of it – with quality very much a case-by-case variable. (Managing Editor James Kirby)

Investing is the art of melding the qualitative and quantitative processes together. When an investor decides direct equity investment is appropriate for them, they are making a conscious decision to compete in an intellectual contest against some of the world’s best minds and some of the world’s worst.

Markets are not always efficient; not all investors are rational; the playing field is not always level;, access to information is not always fair; and financial incentives are often not disclosed. Satisfactory results are certainly not guaranteed.

In such a competitive space, we need all the edges we can develop to aid our chances of success. After all, if we are not beating the market the market is beating us! The key competitive edges investors can focus upon are a view on the business: its Quality and Value derived from a tested and rational approach.

Just avoiding the poor businesses likely to stumble will greatly improve your chances of achieving above-average long-term performance. Focusing on strong businesses and purchasing them when “Mr Market” is in a despondent mood at large discounts to value, then holding these shares with appropriate diversification while their quality remains and they do not trade at prices too far in excess of their current intrinsic value, is the best approach to investing you are likely to find.

What is quality?

Quality is a somewhat subjective attribute. Business quality covers both quantitative and qualitative aspects.

Capitalism and business is all about taking risk and making calculated decisions to generate revenue and profits for shareholders. This risk is taken in expectation of higher returns relative to bonds and to protect the purchasing power of capital from the ravages of inflation. Shareholders that put their capital at risk deserve to be rewarded for taking that risk.

The ultimate cause of corporate failure is usually simply running out of cash, with debt often playing a key role. Fortunately businesses rarely collapse overnight. Signs of weakness are generally apparent well in advance, for all to see. Despite the rosy outlook touted by media, management and brokers recommending you buy a stock, a sound framework, a little effort, and a disciplined approach allow investors to distinguish between the sound stocks and those headed for trouble.

Can quality be measured?

To a large extent, quality is measurable. The audited financial accounts provide our window into management decisions and actions. The accounts show the good, the bad, and the ugly. A company’s accounts tell us all that is needed to spot a weak company that is likely to require a value-destroying diluting capital injection or one that has a high probability of failure.

As such, we set out to derive a consistent, rational and quantitative measure of quality, which we call the Clime Quality Rating (CQR).

What is the CQR, and what does it measure?

Based on 70 pieces of financial data taken from a company’s accounts, the CQR separates companies on the quality of their financial fundamentals at a point in time and over time. A total of 45 ratios are calculated twice a year to look at the performance and solvency of the business and determine the CQR. The CQR is suitable for operating businesses that make money in manufacturing, selling or providing a product or service for customers.

The CQR is based on decades of academic study. We overlay our own views on particular metrics (notably cash flow, profitability and earnings manipulation), aiming to improve the separation of the strong companies from the weak.

Most investors focus their attention on earnings, when they are often best served bypassing the “Profit & Loss” account and focusing on the cash generating ability of the business. Even if a business is reporting accounting profits, it might be losing money on a cash basis. Strong cash flow gives management the ability to invest in the operations, reduce debt, buy back shares and pay dividends. If the company is spending more than it earns on a continual basis, this is a meaningful cause for concern, with the inevitable need to raise capital via debt or equity or to call in administrators.

When looking for quality companies, we focus on finding businesses that can self-fund and create value without excessive leverage. Self-funding means the business generates sufficient cash flow from operations to fund investment in the business and the payment of dividends. Creating value is defined as displaying a level of profitability that exceeds a fair required return or discount rate. One dollar of retained earnings is only worth more than one dollar of value when it can be deployed to generate a return greater than one’s required return. An ability to consistently self-fund and create value are key attributes of a quality business that we measure, not just at a point in time but over time.

Debt is the great accelerator. It aids a company to build a new plant, develop a new product, or build a store network much faster than otherwise may be achievable via retained earnings. Debt can be an accelerator in a negative way, when a business stumbles or the economic conditions take a turn for the worse. In these cases debt becomes a cash drain on a business, reducing its financial staying power. We are wary of companies that are overly acquisitive, particularly when using debt to fund acquisitions. We monitor changes in debt, goodwill and equity over time and look poorly on companies where goodwill and debt are increasing much faster relative to equity and profitability.

We like to see repeatable cash flow and reward the companies that can display this. Negative cash flow occurs when a business spends more than it generates. If this situation occurs over a number of financial periods, the cash outflow will need to be supported by drawing down any available cash at the bank or available lines of credit. When these options run out, the only choice available to a business is fresh injections of equity (capital raisings). Often this weakness is picked up by the market and the share price is discounted meaningfully. When capital is raised after large share price falls, permanent reductions in value often result.

Companies with strong cash flow are the ones to be attracted to. These businesses have the ability to self-fund growth initiatives and pay healthy dividends to owners. This strength is not lost on market participants over the longer term, and is rewarded via share price appreciation.

Earnings can be manipulated. We monitor the accounting treatment of expenses, intangible assets, revenue and inventory and penalise CQRs where we suspect manipulation.

Has CQR been tested?

To test the CQR we constructed two equal weighted indices. One index titled ‘High Quality 50’ contains the top 50 CQR scoring businesses available within StocksInValue. The other ‘Bottom Quality 50’ contains the bottom 50 CQR scoring businesses.

Each index is rebalanced at the end of each quarter. Constituent inclusion/exclusion is driven by their CQR, with each stock assigned an equal weight.

Top 10 stocks by quality

CQR

Name

Description

Share price
(11-2)

P/E ratio (FY14)

Yield (FY14)

ORL

96%

OrotonGroup

Retailer/wholesaler

$3.95

16.64

5.22%

PMV

95%

Premier Investments

Specialty retailer

$7.82

15.63

5.17%

ARP

94%

ARB Corporation

4x4 accessory manufacturer

$10.55

18.53

2.74%

REA

94%

REA Group

Online real-estate

$47.64

40.97

1.21%

MFG

94%

Magellan Financial Group

Fund manager

$11.90

25.26

3.03%

IRE

94%

Iress

Market trading software tools

$9.13

25.71

3.85%

TNE

94%

Technology One

Enterprise software solutions

$2.20

21.88

2.99%

SMX

93%

SMS Management &  Technology

IT consultancy and services

$4.24

17.59

4.53%

NHC

92%

New Hope Corporation

Coal mining

$3.34

26.88

4.20%

PTM

90%

Platinum Asset Management

Fund manager

$6.75

22.68

4.10%

Bottom 10 stocks by quality

CQR

Name

Description

Share price (11-2)

P/E ratio (FY14)

Yield (FY14)

LYC

6%

Lynas Corporation

Mineral exploration

$0.275

-

-

KCN

1%

Kingsgate Consolidated

Gold mining

$1.29

5.28

1.47%

BSA

0%

BSA

Communications & technical services

$0.115

4.42

8.70%

PMP

0%

PMP

Print media production

$0.43

11.62

-

APN

0%

APN News & Media

News & media

$0.43

6.21

0.46%

TSE

0%

Transfield services

Diversified professional services

$0.82

6.95

2.07%

SSM

0%

Service Stream

Network services

$0.235

-

-

FUN

0%

Funtastic

Toy wholesaler

$0.135

5.87

7.41%

CND

0%

Clarius Group

IT & office support

$0.19

3.80

13.16%

EGN

0%

Engenco

Technical products & solutions supplier

$0.16

-

-

Results to December 31, 2013 were:

Source: StocksInValue

As can be seen, the Top Quality 50 have substantially outperformed the Bottom Quality 50 over every period, consistent with our expectation that financially poor-quality stocks are likely to produce poor financial returns. Over four and five years, the Top Quality 50 outperformance is meaningful relative to the benchmark.

Investors are wise to focus on ‘High Quality’ stocks and avoid the ‘Poor Quality’. The businesses that fall between the two groups need more attention to pick the stocks likely to outperform.

Standout performers from the Top Quality 50 are:

REA Group Limited (ASX:REA, 1-year Total Shareholders Returns (TSR) 104.4%).

This business continues to dominate its space in online real-estate advertising, while producing outstanding fundamental returns for its owners. As long as it holds its competitive edge, this business will provide strong earnings for its owners. Today the share price is baking in an extrapolation of past success well into the future, evident in the clearest measure of popularity, the P/E (price-earnings) ratio, which is around 40-times forward earnings. From a valuation point of view the price is trading around December 2016 levels. There is no room for an earnings speed bump while the real-estate market is quite buoyant at the moment. Is the competitive position of this name strong enough? I am not so sure, and the risk of a poor investment return from this price level is elevated. Capitalism has a habit of unleashing creative destruction, just when participants think it is least likely.

Magellan Financial Group Limited (ASX:MFG, 1-year TSR 109.6%)

The international equities fund manager grew funds under management by 233% over the year to December 31, 2013, benefiting from net inflows, favourable market movements, $A depreciation and strong investment outperformance. There is a structural shift in investment allocation favouring managers of international equities over managers of local equities. MFG’s significant and sustained outperformance has driven large retail and institutional inflows. The company’s financial health, reflected in the 94% CQR, is pristine with a debt-free balance sheet and strong cash generation. Returns on equity of 50% are supported by the capital light business model.


David Walker is Head of Equities Research at StocksInValue. George Whitehouse is Portfolio Manager at Clime Asset Management.

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.

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In searching for these prized assets, StocksInValue (a joint venture between Eureka Report and Clime) uses a new quality rating and we are happy to give Eureka subscribers a substantial ‘sneak peek’ at the service today.

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