Head of Equity Strategy
The most simplistic definition of a quality company is a company that over many years can compound shareholder returns faster than the overall market. An example of such a company is Microsoft. From March 1986 to April 2024 (38 years), Microsoft outperformed the MSCI World Index by a wide margin. Not consistently in all sub periods, but the overall price return (so not including recent dividends from Microsoft) has been 26% annualized compared to 8.3% annualized for global equities. That is the magic of a consistent quality company and compounding over time.
If quality is about outperformance, or excess compounding, the next question is how do we identify it ahead of all the great returns? Morgan Stanly and Counterpoint Global have done some great papers on return on invested capital (ROIC) and how it relates to returns. The ROIC concept is essentially the after-tax return a company generates on its invested capital, which equipment, net working capital, intangibles such as goodwill, brand, software etc. The higher a company’s ROIC is the higher its equity valuation is, so this is a good starting point for discussing quality companies.
Because the economy is competitive the ROIC is mean-reverting which means that companies that are enjoying strong returns on invested capital will eventually meet strong competition and see its ROIC drift towards the average. In other words, investors should avoid buying a quality company that turns into an ordinary company. It is all about the ROIC transition.
As the table below shows, the worst stocks over a 3-year period are those that start as the best quality company (top quintile) and end as the worst quality. These companies experience -11% annualized returns over these three years. The best performing stocks are not surprisingly those that start as the worst companies and end as the best companies. These companies deliver 33% annualized returns. These exceptional transitions are difficult to predict. What is interesting is that those that start as the best and end as the best on ROIC deliver 20% annualized returns. Investors are essentially paid for enduring quality. If the company slip to the second best quintile they still deliver 7% annualized returns which is close to the market return.
As one can see from the table above between starting ROIC quintile and ending ROIC quintile over three years it is important to avoid investing in high quality companies that slip into being ordinary – essentially the value trap (buying a falling knife) just for quality companies. That is of course easier said than done, but are different filters investors can apply to reduce the probability of picking the wrong quality companies.
In our screening for high quality companies we set a minimum market cap of USD 10 billion to ensure we get companies of a certain size (often a marker of market reach and strong products). We also require minimum 15% ROIC which is a high threshold in a competitive market economy. Finally, we require total return over 5 years to be above that of the MSCI World. This is to ensure that we are looking at companies that have exceeded or lifted expectations above what the overall market did.
When you have a list of high quality companies the next step is to evaluate the durability of the business in order to be confident that it can remain a high quality company in the future. The “7 Powers” framework by Hamilton Helmer is a good reference for thinking about companies and whether they possess those characteristics of an enduring company.
Based on the screening criteria mentioned above we identified 10 high quality US companies all showing high ROIC and 5-year returns above the market. As the 12-month EV/EBITDA estimates show, high quality is expensive relative to the overall equity market. This is why maintaining the high quality over a longer period of time is so important for future returns. These companies are essentially fighting against high expectations. It is important to stress that the table does say anything about whether these companies have enduring quality, but just that they are quality today. Below we are highlighting some key points for why Apple and Nvidia are high quality companies.
Apple’s quality characteristics:
Nvidia’s quality characteristics:
The European top 10 on quality is listed below and shows companies from a wide range of industries. It is also worth noting that the 10 US companies listed above have an average 12-month EV/EBITDA of 24.2x which is significantly more than the average of the 10 European quality companies at 17.7x highlighting that companies are willing to pay a higher equity valuation for US companies than European. This is one of the reasons why we tactically like European equities more in Q2 than US companies. As with our description of quality characteristics for Apple and Nvidia, we have listed the three key characteristics for Novo Nordisk and ASML.
Novo Nordisk’s quality characteristics:
ASML’s quality characteristics:
The global equity market is big and it can be difficult for retail investors to find the right quality companies. The best way is to find a screening tool that include the option to screen on ROIC and total return, and potentially other things such as net debt and interest coverage (you do not want a leveraged company). Another way of getting a starting list is to look at the holdings list of the largest global high quality ETF which is the iShares Edge MSCI World Quality Factor UCITS ETF. Under the holdings list you can download the entire fund holdings into a csv format and then work from there.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
