How to screen for high quality businesses?
Since the start of the year, challenging macroeconomic conditions have caused a massive selloff in global equities and led to huge portfolio drawdowns among equity investors. The S&P 500 is currently sitting just above bear market territory, 15% below its January peak. With inflation standing at a whopping 8%, the pain may yet be over as the Fed continues to engage in monetary tightening in an effort to combat inflation. While this may signal a temporary downturn, investors with a long time horizon can capitalise on this opportunity by adding shares of high-quality names into their portfolios. In this article, I share how Terry Smith, the founder and CEO of Fundsmith screens for high quality businesses to achieve long term capital gains as a fund manager.
Valuation vs Quality
A common mistake investors make when selecting stocks is looking for cheap companies instead of searching for high quality companies. While valuation does matter to a point where it could affect future capital gains, it is much more important to invest in high quality companies that are able to grow and generate high returns consistently over time.
In a letter to his shareholders, famed value investor, Warren Buffett once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." According to Buffett, quality should be the top criteria investors should prioritise when looking for companies to invest in.
How to measure quality?
- Margins: Margins refer to the amount of profit a company is able to generate after deducting costs. There are two main types of margins, gross margin which measures profit/revenue and operating margin which measures operating income/revenue. These two ratios are useful in measuring the operational effectiveness of a company and its ability to generate profits on its sales in the long run.
- Return on Capital Employed (ROCE): ROCE measures how effective management is in reinvesting capital to earn profits. Companies with ROCEs above their cost of capital will increase in value over time. Investors with the goal of capital appreciation should therefore look to invest in companies with a high ROCE as they are able to reinvest their capital to generate higher returns over time
- Growth: Growth is an important trait for companies to be able to grow their value over time. Coupled with a high ROCE, companies with high growth are able to amplify their returns over time to generate value for shareholders. As leverage is a double edged sword, it can lead to both value creation and value destruction and thus should always be accompanied by high ROCE for positive value creation.
- Economic moat: According to the theory of economics, extreme levels of ROE tend to mean revert due to increased competition in the face of high ROE and curtailments in the face of low/negative ROE. Therefore, businesses pursuing high levels of ROE must sustain themselves with strong economic moats to stave off rivals. Economic moats can come in the forms of brands, patents, technology and control over supply chains and distribution. Therefore, businesses that are market leaders and have a monopoly over sales, distribution and technology tend to outperform their rivals and generate high returns over time.
Screening for quality
For an example to screen for high quality stocks, I used Finviz's stock screener tool to screen for companies using the following parameters:
- Large market cap over $10bln
- High Return on Equity (ROE) > 30%
- High Return on Assets (ROA) > 15%
- High Return on Invested Capital (ROIC) > 25%
- Positive sales growth (past 5 years) > 0%
- High gross margin >50%
- High operating margin > 25%
Source: Finviz
The list of stocks below was generated from the above parameters:
Source: Finviz
From the list, key names such as $Adobe(ADBE)$ , $Microsoft(MSFT)$ and $NVIDIA Corp(NVDA)$ stand out as popular names among investors. As I believe this list is made up of great companies with high quality fundamentals, I plan to conduct more comprehensive research into them before deciding whether to invest in them. As a disclaimer, I currently own shares in ADBE, MSFT and REGN and plan to acquire shares in ASML and NVDA.
Disclaimer: This article is meant solely for informational and educational purposes and does not constitute investment advice. Perform your own due diligence before making any financial decisions.
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