A value investor buys low-priced stocks with pricing factors, growth investor companies that he believes will grow rapidly. A dividend investor is looking for the best dividend payers. Compared to these investment methods, quality investing is much more difficult in the sense that a company’s quality is not reflected in one or even a few key figures.
A quality investor must evaluate a company and its business not only through several key figures but also by weighing perspectives that are not always easily interpreted through numbers.
For 17 years, the Sifter Fund has implemented a disciplined investment strategy for quality companies. When selecting investment targets from more than 65,000 potential companies, we apply these ten golden rules for quality investing:
1. Eliminate, do not pick
Eliminate away the countries, industries and companies you certainly do not want to invest in. In Sifter’s elimination strategy, we exclude companies that produce bulk products, strongly commodity-related industries, purely cyclical companies and all countries with weak investor protection. As a result of this elimination, a manageable number of companies remain to be studied in more detail.
At Sifter, we use various elimination methods to filter the number of shares around the world into about 150 companies that we would like to own if we could buy their shares at a reasonable price.
2. Understand the company’s earnings model
The company’s key indicators reveal if it is better than its competitors. However, it is essential to understand why the company is doing better than its competitors. This is indicated by the company’s earnings model. How does the company create value for its customers? How does it yield higher profits? Often the company’s competitive advantage is precisely related to the earnings model.
The US discount chain Costco is an example of a different earnings model in the mature retail industry. Its distinctiveness and profitability are based on membership fees and membership growth, which in turn enable even lower prices and attract new customers.
3. Prefer growing industries
More than two-thirds of a company’s growth is explained by industry growth. Dying or highly cyclical industries are of no interest. They should be pruned immediately. Admittedly, sometimes even in the low-growth sector, you can find pockets of growth where a different revenue model yields excellent results.
4. Predictability of profits
A large share of continuous services in total revenue always attracts our attention. They bring predictability and often also higher margins. This can mean, for example, a large installed base of equipment that needs maintenance.
The earnings model can also be based on a continuous online service, which is very important to the customer and thus making a profit is also very predictable. The US company Verisign is a prime example of this.
5. Pricing power
If the service or product provided by the company is vital to the customer, it will not be easily replaced. When a company is not exposed to competition, its pricing power is strong. In the electronics industry, such small but vital products can be, for example, quality components or chips. Branded products also have pricing power, whether it’s Starbucks coffee or L’Oreal make-up.
6. High margins
We are interested in gross and operating margins. High margins are a sign of pricing power, differentiation and efficiency. We avoid companies with thin margins. They are exposed if the demand is unbalanced and the fixed costs are not flexible.
7. A strong balance sheet is a valuable asset
The balance sheet of a quality company is strong. Quality companies invest their profits in growing their own operations. They do not need loans. The lack or absence of dividend distribution does not bother us when the return on invested capital is high. That’s when we know a company’s management is able to invest the profits belonging to its owners even more productively, in growing the company.
8. Customer loyalty creates predictability
Customer loyalty is a sign of quality and the service is important to the customer. High customer satisfaction, as well as employee satisfaction, speak of an excellent corporate culture. Best of all, in that case, sales and marketing costs are often lower. Marketing takes place through satisfied customers, and management does not have to spend too much on in-house operations.
9. Competent leadership
Often the management of quality companies grows from within the company. It speaks of a strong corporate culture and continuity. One good example of a good corporate culture is the Swedish Atlas Copco. Similarly, we avoid companies where the CEO or other key management has changed recently.
10. The current price of a share does not always tell the whole truth
High-quality companies are not often found for sale. High-quality companies are always long-term investments. Their value comes from growing profits each year, a part of which they reinvest in the development of their own operations. Ultimately, the share price also follows the growing earnings and cash.
Finding high-quality businesses and investing in high-quality companies is a long-term job.
Many of the items on the list above are easier said than done, and putting these lessons into practice is another issue.
Are you interested in long-term investing? Download our 20-page guide: Long-Term Quality Investing to learn more about how time and high-quality companies work in the investor’s favor.
Sifter Fund has operated as a fund since 2003 and the cornerstones of our approach to investing are:
- Identifying high-quality companies using a systematic process that leaves no room for emotions and guesswork.
- Holding on to investments in high-quality companies for a long time and monitoring changes in their business.
- Keeping a cool head even when the stock markets fluctuate for various reasons.
- Diversifying between 30 high-quality companies, 20 industries and 10 countries.
CEO, Sifter Capital Oy