What is a Quality Stock?

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I’m not expecting this to be hugely lengthy and I am living on the edge by having no plan or anything, but hopefully I can stitch something together that is just about readable and might even make a smidgeon of sense.
 
Whilst creating that ‘Educational’ Blog about Consistency & Volatility the other day (scroll down on the Educational Blogs page and you should find it very quickly), I realised that after 7 years or something of bandying around the term ‘Quality Stocks’ I had never actually made any attempt to try to define that, and this Blog is obviously an attempt to fill the gap (is ‘bandying’ an actual word? The Spellcheck seems happy with it anyway……perhaps it is something to do with Groupies……)

Related to this subject, some time ago I produced a load of Blogs which each contained Checklists which Readers can use themselves or adapt or whatever they wish (chuck them in the WheelieBin if you like !!), and you can find those via this one which has links in it to the others:
 
https://wheeliedealer.weebly.com/educational-blogs/stock-buy-checklist-aim-blue-sky-story-stocks
 
Right, moving on, as I see it in a very simplistic way, a Quality Stock is from a proper Business that has been operating for many years and which has a Track Record of growing Revenues, Profits, Cash Generation, Dividends; and where the potential future suggests growth can continue and the Management have demonstrated their capability over many years and there is a realistic and attractive Strategy. It must have a strong Balance Sheet with little or no Debt and a record of organic growth along with well executed ‘bolt-on’ acquisitions that have shown Strategic sense and price discipline in not over-paying.
 
Embellishing this and adding to it, I would look for the following Attributes (these Bullets might help Readers draw up a Checklist). Please bear in mind that I have not specifically addressed key matters like Valuation and the Charts Set-up here, but my focus is on the actual Business itself and to an extent those other ‘Investment’ elements come later. Not all these Attributes will be relevant to every Company and there may be some where it does not quite meet the standard you would like, which is where your Risk Management and Discretion come into play:

• Established Track Record of success over many years – that may be before Listing on the Market which is fine, as long as you can find relevant information about it.
• Attractive Products with potential for improvement and enduring appeal to the Customer base and scope to add new Customers.
• Diversification across Products and Geographies without overly relying on one particular part of the Business which might face difficulties at some point in the future. Time and again I read Updates from Companies where the overall Results are good but one or two Divisions are not doing all that well. Such diversification can be a big help.
• Evidence of launching new Products (and Enhancements) and having both the capability to create new Products but also to ‘Commercialise’ them with a successful Launch Strategy and appropriate Pricing and Distribution etc., in a way that adds to Revenue and Profits. This obviously can apply to Services in a similar way.
• Proven ability to buy the right Acquisitions at the right price and history of successful integration with the bigger Business and the Balance Sheet strength to enable further buys if available. This means not much Debt and preferably Cash and when they have increased borrowing in the past for Acquisitions, they have shown that they can pay that Debt down within a reasonable timeframe. Evidence of realising ‘Synergies’ that are claimed prior to the Acquisition is nice to see.
• Evidence of ‘Continuous Improvement’ within the Business in terms of things like seeking Efficiency Savings and deploying effective IT Strategies; which both can reduce Costs and enable new ways of working and also provide competitive advantage from being able to create and launch new Offerings.
• Evidence of Management Succession Planning and ability to select good candidates for key roles such as CEO and CFO, in particular. Assuming Business is not many decades old, having Founders involved is often a good thing, especially with smaller Companies.
• Clear signs of Pricing Power – Companies that are at the mercy of Commodity-like Markets where Pricing of their Products is out of their control, can often make stressful investments (think Miners and Oil Companies etc.). A Business that creates a unique Product with true Barriers to Entry will have the ability to set Prices to an extent.
• Barriers to Entry – such things as Patents and established well-known Branding can help give Competitive Advantage and keep the Company ahead of its hungry challengers. Look for decent levels of R&D Spending (Research and Development) and try to identify where the Business has an edge when it comes to attracting, and perhaps more crucially, keeping, customers. Software Companies can be great for this because the customers get ‘locked-in’ due to the costs of switching to another provider (training, integration, migration, teething problems etc. etc.) and they can also get long term Recurring Revenues which give Earnings visibility for future years. Somero Enterprises SOM, which I hold, is an interesting Company in this sense because it gains Competitive Advantage from providing far superior ongoing Support capabilities to Customers who buy its Concrete Levelling Machines (with Concrete setting so fast, you really need slick Support when something goes wrong). This shows the kind of thing that can give an edge. Strong Brands can really differentiate a business and provide a true competitive edge. Just think of Brands such as Ferrari and Disney which dominate their fields.
• If the Business operates in a Cyclical Sector (one that is impacted heavily by a general Economic downturn) then check back in recent tough times (such as the Credit Scrunch in 2009) and look to see how it performed during that crisis and whether or not it had to raise more funds etc. If the Business shows serious signs of distress during such times, you need to think long and hard about whether or not you really want to put money into it; as the recent C19 crisis has shown, things can change dramatically in terms of Economic Growth in an extremely short period of time. Personally, I take the view that Cyclicals can be trading Stocks to an extent, and when they are high and doing well you need to think about whether or not you should be selling.
• Could the Company be a takeover target? Try to think like the Owner of another huge business in a similar sector and consider if the Company we are looking at could be a nice addition to the bigger Group. In addition, would Private Equity be interested in buying it?
• Does the Company have a large Family shareholding? Quite a few smaller Stocks on the Market have a large Shareholding and Director control from a particular Family. In general this is a good thing as the Family has often been involved from day one when the Business was initially formed and may have held for decades or even a century. Many Family members will be employed in the Business and often depend on Dividend Payments themselves every year. As a result, the Businesses tend to be carefully and conservatively run. Companies such as James Latham LTHM, Watkins Jones WJB, James Halstead JHD, Goodwin GDWN and, somewhat strangely, Antofagasta ANTO have large Family stakes. I think Nicholls NICL who do that Vimto stuff are Family run as well.
• Is the Sector one where the outlook is for decent growth? I am a big believer in the idea of Investing in Companies that operate in strongly growing areas such as ePayments, Online Retail, IoT (Internet of Things), Cloud Computing, Big Data, CyberSecurity, Pet ownership, etc. If you buy Companies in decent Sectors then they have a tailwind behind them and even if they aren’t the best businesses, they should still do ok. If you buy Companies in shrinking sectors like Newspapers, Coal production, Banknotes, unfashionable clothing etc., then you are swimming against the oncoming tide and making things difficult for yourself.
• Regulatory Environment – does the Business operate in a sector where Government Regulation can have a big impact? Sometimes this can bring advantages and enable Barriers to Entry, such as in Pharmaceuticals and Medical stuff. For example, Tristel TSTL, which I hold, has lots of Approvals for the use of its Sterilisation products in Hospitals etc. This gives Competitive Advantage and keeps out challengers because it takes time, money and expertise to get such Approvals. In most cases, Regulators can be a right pain. This is particularly the case in Sectors like Gambling, Cigarettes, Utilities etc.
• Does the Company have a Supply Chain that is varied, diverse and flexible? We discovered in the recent C19 fiasco that many Businesses were extremely exposed to overly ‘lean’ Supply Chains which lacked any kind of resilience once Manufacturing or Distribution facilities were forced to close or Transportation was curtailed. I expect to see many Companies addressing this in coming years and already one I hold, Telit Communications TCM, has started building a Manufacturing Site in Vietnam to supplement its existing suppliers.
• Does the Company demonstrate a clear ability to keep ahead of Competitors and/or to at least be up with the Sector Leaders? If you can see they are clearly falling behind, and especially if the reason for the decline is pretty obvious, then you need to think hard about whether or not to invest.
• Does the Business have in-built resilience, such that if a particular Division or product line is struggling, does it have other bits that can more than take up the slack? Businesses that are overly reliant on a small number of Products or limited in terms of Territories in which they operate, may struggle if demand falls away.
• Does the Business have sufficient scale and long-term credibility to ensure that it can gain backing if it needs more Financing in terms of Debt or Equity? Raising more Equity would not be great if it is because of a downturn in the Economy, but often Businesses raise more Money via Share Issuance for a big acquisition or similar opportunity. Is it likely to be able to expand in this way?
• Is this a Company that people are eager to work for? Employees tend to like working for successful businesses and Leaders in their particular field, is this Company a Leader or is it an also-ran?
• Does the Company show evidence of having kept on top of opportunities to increase efficiency and reduce Costs within the Business over time? In a strong buoyant Market where Revenues are growing fast and Profit Margins are meaty, it is easy to spend money and to not control Costs all that well. If you can find Companies that grow whilst keeping track of Costs then this can make a very good investment and it will have resilience if times get tougher.
• Does the Company have control of how its Products are distributed or is it overly dependent on a particular Outlet or does the Distributor actually hold all the cards? Like with Manufacturing and Supply, you need to see diversity and resilience in how the Company gets its Products to the end-users.
• Is the Company taking meaningful steps towards compliance with ESG (Environmental, Social, Governance) standards, and is it doing this with gusto or do you get the sense they are ‘window dressing’ and not really committed to these things? Whatever your own view on ESG stuff, the zeitgeist is for more of this kind of thing and if Businesses do not get behind it and take it very seriously, then it could bite them in the bum hard !!!
• Is there clear evidence of Cash Generation in terms of an increasing Cash Pile and/or reducing Debt levels which tends to be a good indicator of a decent Balance Sheet. If you can sense problems here, the obvious things to check are the level of Debtors, any Intangible Assets on the Balance Sheet, Capitalising R&D Spend on the Balance Sheet rather than expensing through the Profit & Loss Account, Recognition of Revenue before it has actually been earned, etc. If they have a big Cash Pile, check the Interest Earned to see if this is really the case (I got caught out on Patisserie Valerie CAKE for a fraud that I might have spotted if I had checked this).
• Is there a well-defined and sensible Strategy along with Financial Targets perhaps 3 or 5 years out etc.? If the Business outlines a Strategy that has you a bit puzzled and just does not seem to make any sense, then you might want to steer clear.
• Do the Directors have meaningful Shareholdings in the business themselves?
• Are there many credible Fund Management Groups and other types of Institutional Investors on the Shareholder Register? If you can’t see any of the more successful Fund Managers involved, then maybe that’s telling you something.
• An impressive History of raising Dividend Payments over many years and a clear commitment to pay increasing levels (A Progressive Dividend Policy), but within sensible constraints so that the Business retains money for Investment.
• A positive and helpful attitude towards dealing with Private Investors. Many Businesses do not treat Private Investors well and obviously you need to be wary if they are reluctant to answer proper questions and suchlike.
• From what you can tell, is the Marketing approach and Advertising both effective at boosting sales and done at reasonable cost? If you get a sense that Advertising is poorly targeted and wasteful then that is something of concern, clearly. Is the Marketing fresh and exciting, or it is old and stale? Is the Business making good use of Digital Channels? I hold Shares in Go Compare GOCO and something that always impresses me is how they make extremely cheap but highly effective TV Adverts. They have very good Brand Recognition yet don’t spend anything like the Meerkats do !!
• Does the Company have acceptable Waiting Lists for Customers or is this a bone of contention? If Customers face delays when placing Orders then that will not exactly endear them to the Business.
• If the Company has a large element of bespoke/custom work that is does for Customers, is it effective at this or are the Project Management functions letting the side down? This is obviously highly relevant in Construction Businesses and Companies such as BAE Systems BA. which have a large amount of Project work that can be extremely costly if it overruns and/or goes wrong in other ways.
• Are Support Functions efficient and meeting Customer requirements or is this an area where Customer satisfaction is poor?
• Inherent strength in the Business – what I am getting at here is that over time there will be many changes of Management. As Warren Buffett says, sooner or later a total Muppet will come along as CEO and it is important that the Business can still do ok whilst Fozzie Bear is in charge. In effect, a Business that can ‘run itself’ is a very desirable Stock to own. Actually, on reflection, I am not sure that was exactly what Warren Buff said.
• Proficient at steering Market Expectations with regards to Forecasts etc. A Management that continually over promises on the Financial Results and fails to meet these Expectations, will make the Stock a very frustrating one to hold. Ideally you want Management who regularly beat Expectations and are conservative with their Guidance. The odd screw-up here is acceptable and quite normal, but a pattern of missing Targets is not what you want to see.

 
I hope that has covered pretty much everything although I am sure there are bits I have missed out, but I want to get it finished and my brain hurts now !! As it stands, it should give you plenty of pointers in terms of what things matter with a Quality Business and of course all the usual disciplines of assessing Valuation and appropriate Position Sizing for your Risk Tolerance must apply. It is probably a good idea to check out the Chart as well and see if you are buying a Stock that is moving up or something that is actually very out of favour and continually falling.
 
However, putting it simply, if you stick to buying Quality Stocks then you massively weight the luck in your favour and you are much more likely to be successful than if you just buy any old trash willy, nilly.
 
Regards, WD.
 
 
Related Blogs
This one from my mate Justin covers the Balance Sheet and P&L stuff very well (there is a link at the start to Part 1):
 
https://wheeliedealer.weebly.com/educational-blogs/guest-blog-from-justin-scarborough-finance-for-non-finance-people-part-2-company-valuation