Quality Stock Picking

Welcome to the Quality Stock Picking page. Here you can find details of what quality stock picking is, how to find quality stocks and advice on when you should purchase them.

But first, why pick quality stocks?

Markets do generally rise over long periods of time, however, the stock market presents inherent volatility. Prices rise and fall on a continual basis, for many different reasons that we cannot predict. No financial commentator worth anything will pertain to being able to predict market gyrations with any reliability, and the link between economic growth and stock market performance does not carry any reliable correlation either. A quote from Peter Lynch (one of the greatest investors) attests to this (a correction, as mentioned in the quote, means a fall in the market):

 

  “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

 

In light of this, remaining invested throughout the cycle (keeping your money in the market over the long term) is a strategy that has worked well for investors. Almost every year since the S&P500 printed its all-time highs in 2013, there has been a slew of commentators pertaining to a correction being imminent. If you had sold in 2013 you would likely have missed out on 130% worth of gains in the S&P500 to date. Ouch. More damaging to your financial well-being than selling out too early is to sell at a market bottom and not be invested for the reversal. This was seen in the recent collapse due to Covid-19; many pension-fund holders withdrew their equity exposure to 0% believing that this would mark the end of a phenomenal period of returns for stocks. Unfortunately for them, the global market has rebounded — something the world did not predict (looking at the current economic climate you would be forgiven for not believing the market could return to all-time highs).

Regardless of the recent strong outperformance of Quality Stocks vs other areas of the market, I think the benefit to owning quality stocks lies somewhere in the quote and explanation above. If we understand that we need to be invested throughout the economic cycle and for the long-term, we must ask ourselves — what stocks am I happy to own even when the world is on fire? If you can own companies that to a high degree of probability will remain capitalised throughout a crisis, you stand a better chance at not selling out of them in fear, when holding on should be your best course of action. Take this example given by the great British investor Terry Smith: 

 

‘Brown Foreman, the maker of Jack Daniels, has a history of 150 years. It has survived Two World Wars and the Great Depression. It also survived the complete ban of the sale of its products in the Prohibition, for which it applied for a medical license to sell its Whisky!’

 

Brown Foreman is probably a company that will survive a credit crisis. It is also a company that I would feel comfortable owning in any economic environment, which would prevent me from selling at a price detrimental to my financial worth.

 
 

What are quality stocks?

There are many different methods to measure the quality of a business and each parameter will likely vary from investor to investor. However, the baseline criteria for quality companies usually resides in the four characteristics of the Quality Stock Picking Framework below.

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For more on the Quality Stock Picking Framework, click the buttons below

High Operating Profit Margins

The first thing you want to consider when looking for a quality company is profit margins. Companies and industries vary widely when it comes to generating profits. The best ratio to look for is the operating profit margin, which is calculated by:

 

 

A good operating margin is anything above 15%.

When you start considering margins, you will come to realise that some industries are woefully unprofitable; take UK supermarkets for example. A £100 spend usually delivers less than £5 in profit for a supermarket — not much buffer in tough times! This is in comparison to industries such as the tobacco industry, which is able to retain consistently high margins due to high regulation, lack of competition and an addictive product, resulting in industry operating margins of around 40%. This goes a long way in explaining why this industry has been the most profitable investment you could have made over the last 100 years.

A high profit margin is key to long-term investment return, as the more profit a company makes, the more money that that company has which can be returned to investors either through dividends and share buybacks or through reinvestment back into the core business (thus delivering future profits). These profits, as previously mentioned, are also a buffer in tough times.

Various shocks can be delivered to businesses throughout the economic cycle. There are always input costs in the production of goods and services and risk can present itself when a particular input cost rises sharply and the business cannot offset this cost by rising its prices to customers. Let’s take the example of airlines. The main input cost to airlines is oil. Oil is a very volatile good and over the last decade it has ranged in price from 100$ a barrel (unit of oil) to roughly $20 a barrel. If your profit margins at SmoothAirways are 5% (the 2019 industry average) and your oil price shoots up 10% over the course of a month, you are now paying to fly passengers from Heathrow to Lisbon! Unless you can raise your ticket prices by the amount of increased cost (which is unlikely as people will instead fly with another operator) your plane will be left empty! Airlines often offset this by hedging oil costs (buying oil contracts at a fixed price to stabilise their dollar oil costs). Whilst this can save SmoothAirways when the price of oil rises to $100 a barrel (with a contract at $70 lets say), it works against them when oil crashes to $30 and all the new upstart airlines get to fly on cheap oil, leaving SmoothAirways running at double the cost! Bottom line airlines are a nasty business to own, but even businesses with less undesirable characteristics with low profit margins are to be avoided.

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The Operating Profit (or operating income)

 

Revenue

 

A Moat to Defend Margins

So, we are looking for companies that have high profit margins. However, the unfortunate thing with high profit margins is that there is usually an excited mob who have evaluated these margins and then decide to enter the market to compete. Therefore, without anything to defend profit margins, economic theory suggests that the existence of such competition will beat down any profits to zero. This should technically happen in a business such as milk or taxi services. To a reasonable extent, a consumer doesn’t care what milk they drink or which taxi they ride in. This means that the only factor they consider is price, which results in fierce price competition and low profit margins.

 

The businesses that we are trying to find have economic moats. These moats put distance between market incumbents and competitors looking to take market share, thus preventing the competitor from lowering prices to take customers from and reduce profits for the incumbent. Moats come in many forms, but can usually be found as brands, intellectual property (patents, copyrights and trademarks), distribution channels and high-sunk costs.

 

Brands are a fantastic barrier to entry. Often built over decades, sometimes even hundreds of years, a company with a strong brand (for example Louis Vuitton, which you could own with LVMH shares) will command a large price premium over a generic good of the same quality, for which the right customer will be willing to pay. This brand heritage cannot be formed in a short period of time, nor is it a small cost to impersonate, and therefore represents itself as a moat to competition.

Patents are as solid a moat as can be found, especially a long duration patent. This type of intellectual property prevents competitors from manufacturing or selling the same product or technology. Let's take the example of Intuitive Surgical. Intuitive sells DaVinci robotic systems to hospitals and surgeries around the world. These extremely complex robotic surgery machines are not only very difficult to replicate (you would need to employ a robotic genius to rival the hardware), they are also patent protected, which prevents anyone from copying the design. This eliminates the ability for new market entrants to build something similar and compete with Intuitive on price.

Next, we have distribution channels as a form of economic moat. These usually represent themselves in physical goods industries. For example, in the sector of fast-moving consumer goods (FMGC), a manufacturer such as Nestle must go through a distributor to get its KitKat bars onto retail shelves. These distributors purchase the product at scale and take a small margin for the supply of all goods to local retailers. This isn’t always creational of a moat, in fact, the presence of distributors actually improves competition and allows businesses of any size to achieve scale. However, the devil is in the detail, and some companies will make the clever move of purchasing their key distributors. This essentially helps them to become the sole or preferred supplier, but more importantly, they can then choose not to accept new entrants to distribute their products. Take the example of Logista Distribution, one of Europe’s largest convenience store distributors. Much of the snack food, alcohol, tobacco and pharmacy products across continental European markets will have been distributed by Logista. If you look at their company ownership, you will find that 50.5% of Logista's shares are owned by Imperial Brands (a global tobacco company), which is just enough ownership to have control of the linchpin to European convenience store distribution of tobacco.

Finally, we have sunk costs. This moat will often occur with industrial companies, where the initial purchase of heavy machinery outlays such a significant cost that the customer will never replace it! The smartest companies will aim to capitalise on this effect by charging the customer an annual fee to come and service the product, usually at a much more profitable rate than the rate at which they sold them the initial good. Let’s take the elevator industry for example. If you decide to build a skyscraper in an urban centre in Britain, it is likely you will need an elevator to comply with building regulations. The installation costs will be significant: concrete, wire cabling, the lift itself — you only have to watch Die Hard once to understand the complexity of installing one of these things! The company will likely install the lift for a meagre profit of 10%. However, they know that after you make the purchase, their elevator will be rocketing up and down your high rise building for the next century to come. You will then be forced to comply with regulations in having your elevator inspected and maintained on a frequent basis, which they will happily come back and perform at the cost of inspection and extra parts, plus 70% mark up. This elevator therefore acts as a bond for these companies, providing a reliable income stream regardless of wider economic situations.

 

Sustainable Revenue Growth

You can find the most profitable company in the world, which has incredible economic moats, but if it cannot grow its revenues it won’t likely do brilliant things for your portfolio. Without growth, the underlying value of the business you own will not change. As investors, we not only receive value from the profit generation of companies, but also from the underlying valuation of the business — reflected in the stock price. By holding on to companies that grow revenues over time, you expose yourself to the great economic power of compounding. 

Compound returns work in an investors favour due to the multiplying effect of additional units invested. If we use a really simple example of a farm: if it takes ten cows a year to sell enough milk to buy another cow, once you have bought the next cow, eleven cows will generate more additional units of milk in that given year. After ten years (assuming these cows are still alive and you commit to buying one new cow a year) you will have twenty cows producing double the amount of income per year. Should you then choose to purchase another cow, it would take only half a year to sell enough milk to buy that new cow. In order for companies to return exponential value to shareholders they must grow themselves.

Let's take another very crude example of two companies: Company A — a very profitable, but stagnant, grower; vs Company B — a less profitable, but fast growing, company.

Company A has revenue of £1000 and generates profits that can be returned to shareholders at 50% a year. However, they cannot grow revenues at all. After five years, the cash returned to shareholders will equal £500.

Company B also has revenues of £1000 and generates profits that can be returned to shareholders at 10% a year. However, Company B can grow its revenues at 20% per year. This means that by the end of the fifth year, Company B has revenues of £2500 and will be generating £250 cash attributable to shareholders. By the ninth year, it will be generating £5000 and the equivalent return of £500 to shareholders.

This is the point at which the pendulum swings into the long term investors favour, because in the fifteenth year, Company B is generating £15000 and £1500 return to shareholders (all other factors being equal).

You may be thinking, why would I wait nine years to achieve the same return as one year in a highly profitable, but stagnant, company? Well, as investors, we don’t just own a share of underlying profits, we also own a piece of the business itself, and that has a value. Let’s assume these two companies at the start are valued on the same price to sales metric of 10x sales. Therefore, in year one, both company A and B are worth £10,000. However, by year five, Company B, with revenues of £2500, is now worth £25000. Let’s then consider total return at year five. Company A with revenues of £1000 will still be worth £10,000, plus attributable profits over the five year period of £500 per year will equal £2500, making the total value of the company £12,500. This means that after a five year period, investors aggregated were £12,500 better off choosing company B, even before attributable income has been given to B shareholders.

Although we are therefore looking for fast growing companies, there are a few caveats to mention. The first is the question of the sustainability of revenue growth. There is no point chasing companies that are growing revenues spectacularly over a short period of time, that then indefinitely kick into reverse when an economic cycle changes. Take an oil company for example. Revenues are derived by total output (barrels of oil) x price of oil. In a good year, the oil price could double, essentially doubling revenues, likely taking the share price to heady heights. But you would be brave to believe that that level of growth or any continued growth in oil price was a promise. When the price of oil inevitably falls, so will your companies revenue and in turn its share price.

The second caveat is the price to which the market demands for that growth and ensuring you don’t overpay for it. The price of a company on a listed exchange is an arbitrary figure. Whether trading at 10p or £40 per share, this neither makes a company ‘cheap’ or ‘expensive’. You need to compare its price to the underlying earnings the company delivers or the sales it generates (P/E meaning Price-to-Earnings or P/S meaning Price-to-Sales ratios — more on valuation here). If a company is growing revenues at 100% a year, it is likely the market would have placed a very high multiple of P/E for that company. You could end up paying plus 100x the company's earnings (essentially saying if the company's earnings were to remain unchanged at today's level you would have to wait 100 years for a return!). So the trick is to buy growth companies, but not at levels that mean the company will have to either grow at insane levels for an unsustainably long time, or that you would have to hold for your whole life to see any value from your investment.

 

Prudent Management Team

This is probably one of the things that is hardest for investors to quantify, as we can only be sure of prudence in hindsight. A prudent management team will steer the ship of your chosen company, nurture it through good and bad times and most importantly avoid destroying capital. So how can we quantify prudence and what should we look for? I think the easiest answer to that question is to understand what destructive management looks like.

Destructive and incompetent leaders are everywhere; they rise to the top of small companies, global organisations and government bodies in equal fashion. Here are some key red flags to look for:

Paying Unsustainably High Dividends in the Face of a Large Debt Balance

Debt can be a good thing; a little leverage added to a profitable and growing business can amplify returns. However, ladening the business with too much debt is never prudent, which sometimes happens when undertaking large acquisitions. A general rule of thumb is to keep net debt as a ratio to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) under 2 times. Debt levels aside, a really incompetent thing for management to do is pay an unsustainably high dividend in the face of a poor financial environment for the company, or worse when debt levels are very high. It happens reguarly, a company will be considered an ‘income paying share’ or a ‘dividend stock’ which essentially means shareholders own the business for the purpose of receiving its healthy dividends. This usually pertains to companies in low growth industries like telecoms, utilities, resources and consumer goods. Management often get into the self perpetuating cycle of diverting much needed capital away from the business and into shareholders pockets in the form of dividends. In some cases, the company will go through a loss making period and will still pay the dividend by taking on debt in order to make these dividend payments! This can create issues when management prioritise dividends over debt repayments, that eventually build over time and reduce the overall value of a company.

Acquisitions

My favourite terrible management decision! Don’t get me wrong, many businesses create enormous value with acquisitions. These will often be small, bolt-on acquisitions that are in the same line of business as the core operations of the company. Take Bunzl for example, this FTSE100 stalwart has created value for years by purchasing smaller distribution businesses that fit beautifully into the larger organisation. The alarm bells should start ringing however, when the management team of a hotel business start preparing to buy an airline. It will create transformational opportunities they say, until they realise that running an airline is actually an entirely different ball game to running a hotel chain; their years of skill, knowledge and added value in the hotel industry will not apply to their latest airline venture. What's more, now that their attention is divided across both ventures, quality slips in both! This probably seems an obvious point, but time and time again companies buy other companies in entirely different industries thinking it makes sense.

A recent acquisition of this form would be Bayer’s takeover of Monsanto, which is a fantastic case study if you fancy the read. Essentially, you have a pharmaceutical supplier with a veterinary healthcare business that thinks it's a good idea to buy the world's largest Agri-seed business Monsanto. Aside from the fact that Monsanto is a terribly unethical company, I fail to see where any cost savings lie between the two businesses or in fact where Bayer could add value to Monsanto. Long story short, Bayer forgot to do any due diligence during their frenzy to buy and the long list of legal cases in America for Monsanto’s key product RoundUp have created a 10 billion dollar litigation suit for Bayer to stump up for. Now laden with debt from the purchase, the share price has more than halved due to the bad acquisition and the litigation suits. Bayer is considering selling its animal health unit to keep afloat. It is ‘transformative’ acquisitions like these that you should be wary of as an investor.

Failure to Break Up Organisations

Just as much as acquiring a totally different company to your core business can destroy value, keeping your company that has many different businesses under one roof can prevent value creation too. Say that you had a large company with two business units: a high street bank that also owns a digital payments company, weighted 70% to the stable, low-growth business of the high street bank and 30% to the digital payments company. 'Growth' and 'quality' investors don’t want to own a bank (for various reasons) and therefore the stock trades on a ‘cheap’ price to earnings of 9x. However, the digital payments arm is fast growing, and if it were a standalone company it would achieve a much higher multiple of around 30x P/E. Therefore, if the payments company were to be broken out from the larger business, it would receive a valuation of around 3x its current market value. However, management often doesn’t want to break their business up, even in the case that there are increased costs to operating as a whole entity or if one business unit is loss making. I have my own ideas as to why. Whether this is to fulfill egos at the top of larger empires or provide easier justification to pay CEO's inordinate salaries due to the larger revenue base. Perhaps it's because the leadership simply wants to follow the status quo, or even worse, that they aren’t aligned with shareholders.

Larger Than Life CEOs

Being a CEO of a multi-million or multi-billion pound company could get to your head! Of course, many professionals have humble authority and candour, however, there are some individuals at the top of companies who, to put it best, are on a power trip. Being larger than life can be fine. Many entrepreneurs who create massive value for shareholders can be unique characters. However, when the individual seems to be spending more time in front of the media or behaving in an attention-seeking manner on twitter than they do in the boardroom, it could be a cause for concern. It can often be these types of characters that take the company down the empire building route with their destructive but ego-fuelling acquisitions. The example of Mike Ashley (CEO of Sports Direct) comes to mind. Articles describing boardroom antics, pub gambling pursuits and alcohol related inducements seem to pop up in equal fashion to every UK retail business Sports Direct is looking to pounce on or ‘save’ from the dismal high street crisis.

Ethical Malpractice

Company ethics and shareholder returns are becoming more correlated with time as we, as a global society, become more concerned with ethical malpractice. Whilst government bodies could do much more, the amount to which corporations can ‘get away’ with bad behaviour now is significantly less than a few years ago. There are many ways ethical malpractice can damage shareholder returns. Regulators can provide hefty fines, consumers can boycott purchasing their goods and services and suppliers can even withdraw from working relationships. It is somewhat difficult to predict or avoid an ethical issue arising from one of your companies (unless they operate in a notoriously unethical industry — for which you should be prepared for these issues in valuation terms) but if it occurs once, it should be a warning that it will likely occur again. This is really dependant on a term called ‘governance’. Companies with weak governance leave the door open to ethical malpractice. If the governance isn’t replaced or improved after an outbreak, investors should be prepared for it to happen again. Take the example of Spire healthcare, the UK private hospital operator which has been embroiled in a number of scandals, and the unfortunate events of the Ian Patterson scandal. In 2017, the Spire Healthcare surgeon was sentenced for the criminal offence of operating on women who need not undergo surgery, often causing irreversible damage to patients in the process. This is obviously a horrible event that you could not foresee happening as an investor. However, you have to ask the question of how did this event occur? How was Dr Pattison left unchecked for such a period of time to commit these offences? What governance was in place to prevent such an event occuring? At the time of the offence, I don’t remember hearing much response from the company other than its legal defence. There was certainly no talk of a governance overhaul. Recently, in January 2020, Spire has recalled over 200 patients over concerns of another surgeon undertaking unnecessary operations. This will cause further reputational damage, and although the case has not been concluded, it shows poor governance left the door open to this situation happening again. In a further blow to Spire in June 2020, it has been alleged by the Competitions and Markets authority that they have been engaged in price fixing (illegal and anti-competitive behaviour). The answer for investors here after the first ethical breach was to review what governance had been put in place after the scandal. The damage ensued in Spire Healthcare’s case exemplifies what occurs when nothing is done.

So What Does Prudence Look Like?

We’ve mentioned above some of the characteristics of value-destructive company management. So what are some things we can look for that show prudence?

 

The first thing we can look for is track record. How long have senior staff been in the role and what results have they produced? Do results vary wildly or do they produce a nice consistent upwards curve in earnings matched by a modest increase in operating expense?

Secondly is senior staffs' alignment with shareholders. How much of the company do they own? It's not unusual for senior executives to hold significant amounts of company stock — the more the better in my opinion (up to a limit; I succinctly remember the American Airlines CEO asking to be paid only in stock in 2018 as the company was a sure bet — I wonder how he felt at the peak of the Covid-19 pandemic!). A holy grail for investors when it comes to alignment with shareholders is family ownership. When a company is passed down from generation to generation, often seen in many European businesses, they are often looked after by family stewards with care and respect in order to hand the company to the next generation in a better condition than when they received it. This often prevents the leadership team from performing any value-destroying acts, encouraging them to focus on the core business.

Another prudent thing to observe is financial management. It’s always positive as an investor to hear of companies that are operating with little leverage (amount of debt) or that are carrying net cash on their balance sheet. Furthermore, when it comes to finances, it is always good to see a company not fiddling with its accounts too much. Pretty much every company report these days will list its income and earnings as ‘adjusted’ on their published accounts. This means actual reported income or earnings are in fact lower than the ‘adjusted’ amounts. The company is allowed to adjust these earnings in the case of impacts to reported earnings coming from one-off instances — for example an Acquisition or a large one-off fine from a regulator. What you don’t want to see is a habitually large gap between ‘adjusted’ and ‘reported’ earnings — particularly on a continued basis! The best companies will report no adjustments, or when reading the report the adjustments are infrequent or negligible.