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In the first of our four-part series on the fundamental factors of investing, Tyler and Jordan sit down to discuss the “quality factor” and what makes a quality company. Our discussion revolves around operating efficiency, earnings quality, and leverage and capital structure. Keep in mind that the figures we discuss vary by industry, company size, and geography.
First, we identify the pillars in operating efficiency that demonstrates a quality business, including returns on equity and assets, and gross and operating margins. Return on capital such as equity and assets measure a company’s net income relative to the value of its equity or assets. Over the past year, the S&P 500 return on equity (ROE) was around 20% and its return on assets (ROA) was 4%. The other ratios we identify as being operationally efficient are gross and operating margins. Gross margins are the company’s sales less cost of goods sold. Put another way, it is the amount of money the company retains after its direct costs associated with producing its goods or services. Operating margins are your profits after both cost of goods sold and other operating costs such as sales, general, and administrative costs (SG&A), marketing, and research and development costs (R&D). The S&P 500 gross margins are roughly 34% with 15% operating margins.
Second, we discuss earnings quality and earnings stability or variability. These fundamentals are typically revealed by finding and removing anomalies in one-time events or accounting tricks. When we look for high quality earnings, we look for companies that grow free cash flow with net income. Various accruals ratios are used in the industry to highlight companies with high or low quality of earnings, but it is more challenging to calculate across a basket of stocks like the S&P 500 which has continuous changes in its make up and weightings.
Next, we review leverage and capital structures to identify high-quality balance sheets. Companies that employ a lot of leverage have the ability to boost earnings during expansions, but earnings generally deteriorate faster when the economy slows. Our philosophy is to find the right balance between an optimal capital structure that gives you some positive financial leverage during the good times while having the ability to make it through the economic contraction portion of the economic cycle. We would identify a company with lower debt relative equity or assets as high quality and a company that has strong earnings before interest depreciation and amortization (EBIDTA – an industry norm for measuring cash flow) relative to its net debt balance as high quality. According to Bloomberg’s calculations, the current S&P 500 debt to equity ratio is 115% and the net debt/EBIDTA is roughly 1.6x.
Finally, we discuss some more subjective factors of quality including good management, brand, pricing power, and economic moats. Strong management can be analyzed by having strong returns on capital figures, long-term success in allocating capital, and stable management teams. Brand is strongly related to pricing power and the ability to continue to raise prices (particularly in an inflationary period). An economic moat is a term that refers to a business's ability to maintain a competitive edge over its competitors. Companies with economic moats have size, cost, or other intangible advantages.
We end with a quote with from Warren Buffett’s 1989 shareholder letter that will lead us into our next discussion on the value factor. "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."