Quality investing is an

investment strategy In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics an ...

based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft (e.g. management credibility) and hard criteria (e.g.

balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...

stability). Quality investing supports best overall rather than best-in-class approach.

History

The idea for quality investing originated in the

bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemica ...

and

real estate investing Real estate investing involves the purchase, management and sale or rental of real estate for profit. Someone who actively or passively invests in real estate is called a real estate entrepreneur or a real estate investor. Some investors actively ...

, where both the quality and

price A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the c ...

of potential investments are determined by

rating A rating is an evaluation or assessment of something, in terms of quality, quantity, or some combination of both. Rating or ratings may also refer to: Business and economics * Credit rating, estimating the credit worthiness of an individual, c ...

s and expert attestations. Later the concept was applied to investments in enterprises in equity markets.

Benjamin Graham Benjamin Graham (; né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American economist, professor and investor. He is widely known as the "father of value investing", and wrote two of the founding texts in neoclassical inves ...

, the founding father of

value investing Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...

, was the first to recognize the quality problem among equities back in the 1930s. Graham classified stocks as either Quality or Low Quality. He also observed that the greatest losses result not from buying quality at an excessively high price, but from buying Low Quality at a price that seems good value.

Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net w ...

said that one wants to buy companies that can be run by idiots, because some day they will be. The quality issue in a corporate context attracted particular attention in the management economics literature following the development of the BCG matrix in 1970. Using the two specific dimensions of

life cycle Life cycle, life-cycle, or lifecycle may refer to: Science and academia *Biological life cycle, the sequence of life stages that an organism undergoes from birth to reproduction ending with the production of the offspring *Life-cycle hypothesis, ...

and the experience curve concept, the matrix allocates a company's

products Product may refer to: Business * Product (business), an item that serves as a solution to a specific consumer problem. * Product (project management), a deliverable or set of deliverables that contribute to a business solution Mathematics * Produ ...

– and even companies themselves – to one of two quality classes ( Cash Cows and Stars) or two Non-quality classes (Question Marks and Dogs). Other important works on quality of corporate business can be found primarily among the US management literature. These include, for example, "

In Search of Excellence ''In Search of Excellence'' is a book written by Tom Peters and Robert H. Waterman Jr. First published in 1982, it sold three million copies in its first four years, and was the most widely held monograph in the United States from 1989 to 2006. T ...

" by Thomas Peters and Robert Waterman, "

Competitive Advantage In business, a competitive advantage is an attribute that allows an organization to outperform its competitors. A competitive advantage may include access to natural resources, such as high-grade ores or a low-cost power source, highly skilled ...

" by

Michael Porter Michael Eugene Porter (born May 23, 1947) is an American academic known for his theories on economics, business strategy, and social causes. He is the Bishop William Lawrence University Professor at Harvard Business School, and he was one of t ...

, " Built to Last" by Jim Collins and Jerry Porras, and "

Good to Great ''Good to Great: Why Some Companies Make the Leap... and Others Don't'' is a management book by Jim C. Collins that describes how companies transition from being good companies to great companies, and how most companies fail to make the transition ...

" by Jim Collins. and " Quality Investing" by Lawrence Cunningham Quality investing gained credence in particular after the burst of the

Dot-com bubble The dot-com bubble (dot-com boom, tech bubble, or the Internet bubble) was a stock market bubble in the late 1990s, a period of massive growth in the use and adoption of the Internet. Between 1995 and its peak in March 2000, the Nasdaq Compo ...

in 2001 when investors witnessed the spectacular failures of companies such as

Enron Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. It was founded by Kenneth Lay in 1985 as a merger between Lay's Houston Natural Gas and InterNorth, both relatively small regional companies. ...

and

Worldcom MCI, Inc. (subsequently Worldcom and MCI WorldCom) was a telecommunications company. For a time, it was the second largest long-distance telephone company in the United States, after AT&T. Worldcom grew largely by acquiring other telecommunic ...

. These corporate collapses focused investors’ awareness on quality, which may vary from stock to stock. Investors started to pay more attention to quality of balance sheet, earnings quality, information transparency, and

corporate governance Corporate governance is defined, described or delineated in diverse ways, depending on the writer's purpose. Writers focused on a disciplinary interest or context (such as accounting, finance, law, or management) often adopt narrow definitions th ...

quality.

Identification of Corporate quality

As a rule, systematic quality investors identify quality stocks using a defined set of criteria that they have generally developed themselves and revise continually. Selection criteria that demonstrably influence and/or explain a company's business success or otherwise can be broken down into five categories: 1. Market Positioning: quality company possesses an economic moat, which distinguishes it from peers and allows to conquer leading market position. The company operates in the industry which offers certain growth potential and has global trends (e.g. ageing population for pharmaceuticals industry) as tailwinds. 2.

Business model A business model describes how an organization creates, delivers, and captures value,''Business Model Generation'', Alexander Osterwalder, Yves Pigneur, Alan Smith, and 470 practitioners from 45 countries, self-published, 2010 in economic, social, ...

: According to the BCG matrix, the business model of a quality company is usually classified as star (growing business model, large capex) or cash cow (established business model, ample cash flows, attractive dividend yield). Having a competitive advantage, quality company offers good product portfolio, well-established

value chain A value chain is a progression of activities that a firm operating in a specific industry performs in order to deliver a valuable product (i.e., good and/or service) to the end customer. The concept comes through business management and was firs ...

and wide geographical span. 3.

Corporate Governance Corporate governance is defined, described or delineated in diverse ways, depending on the writer's purpose. Writers focused on a disciplinary interest or context (such as accounting, finance, law, or management) often adopt narrow definitions th ...

: Evaluation of corporate management execution is mainly based on soft-criteria assessment. Quality company has professional management, which is limited in headcount (6-8 members in top management) and has a low turnover rate. Its corporate governance structure is transparent, plausible and accordingly organized. 4. Financial Strength: Solid balance sheet, high capital and sales

profitability In economics, profit is the difference between the revenue that an economic entity has received from its outputs and the total cost of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs. It i ...

, ability to generate ample

cash flows A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...

are key attributes of quality company. Quality company tends to demonstrate positive financial momentum for several years in a row. Earnings are of high quality, with

operating cash flow In financial accounting, operating cash flow (OCF), cash flow provided by operations, cash flow from operating activities (CFO) or free cash flow from operations (FCFO), refers to the amount of cash a company generates from the revenues it brings in ...

s exceeding

net income In business and accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, a ...

inventories Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying the shap ...

and accounts receivables not growing faster than sales etc. 5. Attractive valuation: Valuation ultimately is related to quality, which is similar to investments in real estate. Attractive valuation, which is defined by high

discounted cash flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate devel ...

(DCF), low P/E ratio and

P/B ratio The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market value to its book value (where ''book value'' is the value of all assets minus liabilities owned by a company). The calculation can be performed i ...

, becomes an important factor in quality investing process. According to a number of studies the company can sustain its quality for about 11 months in average, which means that quantitative and qualitative monitoring of the company is done systematically.

Comparison to other investment models

Quality investing is an investment style that can be viewed independent of

and

growth Investing Growth investing is a style of investment strategy focused on capital appreciation. Those who follow this style, known as ''growth investors'', invest in companies that exhibit signs of above-average growth, even if the share price appears expens ...

.Quality as an Independent Style. Implications for Portfolio Construction.
Study by Dr. Wolfram Gerdes. November 2009. A quality portfolio may therefore also contain stocks with Growth and Value attributes. Nowadays, Value Investing is based first and foremost on stock valuation. Certain valuation coefficients, such as the price/earnings and price/book ratios, are key elements here. Value is defined either by valuation level relative to the overall market or to the sector, or as the opposite of Growth. An analysis of the company's fundamentals is therefore secondary. Consequently, a Value investor will buy a company's stock because he believes that it is undervalued and that the company is a good one. A quality investor, meanwhile, will buy a company's stock because it is an excellent company that is also attractively valued. Modern Growth Investing centers primarily on Growth stocks. The investor's decision rests equally on experts' profit

forecasts Forecasting is the process of making predictions based on past and present data. Later these can be compared (resolved) against what happens. For example, a company might estimate their revenue in the next year, then compare it against the actual ...

and the company's

earnings per share Earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock for a company. It is a key measure of corporate profitability and is commonly used to price stocks. In the United States, the Financial Accounting ...

. Only stocks that are believed to generate high future profits and a strong growth in earnings per share are admitted to a Growth investor's portfolio. The share price at which these anticipated profits are bought, and the fundamental basis for growth, are secondary considerations. Growth investors thus focus on stocks exhibiting strong earnings expansion and high profit expectations, regardless of their valuation. Quality investors, meanwhile, favor stocks whose high earnings growth is rooted in a sound fundamental basis and whose price is justified.

History

Identification of Corporate quality

Comparison to other investment models

See also

References

Further reading