How to Identify High Quality Stocks (Part 3a of 4)

What does it mean to measure a business’ “quality” in the context of investing in common stocks? We try to answer this question in Part 3 of our overview of optimizing a systematic value investing approach – how to identify low risk, high quality, undervalued stocks that generate market beating returns.

In our first two installments, we discussed first how to avoid permanent capital impairment, and second, how to measure whether a stock is cheap. In Part 3, we review how we can measure quality, and thereby screen for and identify high quality stocks. Within Part 3, there two broad areas to review, so instead of composing one long blog post, we broke Part 3 into two parts, Part 3a (set forth below), covering economic moats and their measurement, and Part 3b (coming soon), covering financial strength.

Below we highlight the stage of the quantitative value process we’ll be focused on:

Here is an outline of our approach to identifying quality. As previously mentioned, in this post we focus on Franchise Power and in our next post on quality we’ll cover Financial Strength.

1. Franchise Power
   • High Returns
   • Margin strength and stability
2. Financial Strength (to be covered in a future post, part 3b of 4)

Franchise Power

High Returns

In thinking about franchise power, we turn to the sage of Omaha for guidance. Warren Buffett looks for businesses with enduring competitive advantages that differentiate them from competitors, and provide them with sustainable earnings power. What kinds of competitive advantages might those be? Such advantages can take many forms; a firm might have some manufacturing cost advantage, provide a product for which there are no direct substitutes, or have a trusted brand that keeps customers coming back. These types of advantages, and others like them, are factors that allow companies to defend market share, similar to how a moat protects a castle from aggressors. Warren Buffett has written extensively on the concept of the “economic moat,” which refers to a company’s ability to maintain these kinds of competitive advantages, and thus repel invading competitors.

As a “quant,” we are not focused on understanding the details of the many types of competitive advantages or how they are maintained (although we sometimes blog about the moats of specific companies). Instead, we want to know how best to identify which metrics are the appropriate ones to consult when assessing an economic moat and its durability. A key feature of economic moats  is that they enhance profitability, and thus allow firms to generate above-average returns on invested capital. The business with a wide moat therefore requires lower rates of reinvestment to maintain or grow existing production capacity, leaving additional capital that can be distributed to owners without affecting the company’s growth prospects. It is for this reason that we look to methods of measuring profitability as a means of identifying companies that possess economic moats.

In reviewing returns, we are particularly interested in those companies that have demonstrated the ability to generate high returns over a fairly long time frame, which indicates these companies have sustained returns over a full business cycle and may continue to earn excess returns in the future. We use eight years for our long-term average return calculation, as this captures a typical boom-bust business cycle, and provides us with enough stocks with adequate historical data to form a large universe to screen.

Our first economic moat metric is long-term free cash flow on assets (CFOA), which is the sum of eight years of free cash flow (net income – depreciation & amortization – changes in working capital – capital expenditures) divided by total assets, or:

CFOA = Sum (Eight Years Free Cash Flow) / Total Assets

This metric captures how much cash in excess of capital expenditures the company has generated over the preceding eight years. Microsoft Corporation, for example, is a company that has generated eight years of free cash flow that sum to well over 100% of its total assets, earning it a high CFOA score, and indicating the presence of an economic moat. Such strength seems consistent with Microsoft’s entrenched position in the market for operating systems for new computers and in multiple business applications, which are sources of self-sustaining market share. Arguably, Microsoft is facing competitive problems going forward, but historically, there is no denying that MSFT knows how to dominate the competition.

Our next metric is long-term geometric return on assets (for our purposes, return on assets (ROA), which is simply: net income before extraordinary items / total assets). We use the geometric (versus arithmetic) mean because it penalizes volatility. Volatility in the context of ROA is a sign the firm’s economic moat is questionable. The geometric mean of the eight year ROAs is obtained via the following equation:

8 yr. ROA = (((1+yr 1 ROA)*(1+yr 2 ROA)…(1+yr 8 ROA))^(1/8)) – 1

For additional robustness, we supplement our 8 yr. ROA metric with long-run returns on another common metric: return on capital. We define return on capital (ROC) as: EBIT (1-tax rate) / (book value of debt + book value of equity – cash). We take the geometric mean of eight years of ROCs, employing the method used above with 8 yr. ROA.

It makes sense that firms that can generate persistently strong returns, scaled by assets and capital, over long time frames, are likely to possess at least some characteristic that defines an economic moat, i.e., a sustainable competitive advantage. For example, we recently reviewed 8 yr. ROA and 8 yr. ROC performance for Coca-Cola Company, and observed that the firm had returns of 14.8% and 21.4%, respectively for those metrics, placing the company in the top 5% of our screening universe for each metric. Clearly, Coca-Cola’s extremely well-known worldwide brand allows it to generate unusually high returns consistent with a wide economic moat.

Margin Strength and Stability

While returns tell part of the story, additional metrics that can shed light on the existence of an economic moat relate to profit margins. A moat, or franchise, can allow a firm to maintain or enhance profitability. We quantitatively assess the ability to maintain or enhance profitability via 1) profit margin growth and 2) profit margin stability.

Our first margin metric is margin growth, or MG. MG represents the long-term (8 year) geometric growth in a company’s gross profit margins (GM), so MG is equal to:

((yr 1 GM/yr 2 GM)*(yr 2 GM/yr 3 GM)…*(yr 7 GM/yr 8 GM))^(1/7)-1

As one can see, we are interested in measuring the compound growth rate of margin increases. Apple Inc., for example, expanded its gross margins from 28% in 2004, to 42% in 2011, at a compound rate of 6.16%, good for the 93rd percentile of our screening universe. Apple’s products are brilliantly engineered and wildly popular, so it is able to command a hefty price premium and grow margins over time, which reflects its economic moat.

While growing margins are a sign of pricing power, and thus of the presence of an economic moat, low or no growth and thus consistent and highly stable margins can also signal a wide moat. Consider Proctor and Gamble, which has a variety of strong brands that people trust and continue to use over time, and which have collectively generated approximately 50% margins for the company for many years. We calculate margin stability by dividing the average gross margin over the past eight years, by the standard deviation of those gross margins over the period, or: average GM / standard deviation GM. When we recently measured Proctor and Gamble, it had an 8 yr. average gross margin of 49.8%, with a standard deviation of 1.4%, leading to a rock solid margin stability value of 36.5, boosting the company into the 97th percentile. It would seem the economic moat created by Procter and Gamble’s brand value is reflected in its exceptional margin stability.

Armed with our two separate gross margin strength metrics, growth and stability, we can now directly compare two companies, even with disparate economic moats, such as Apple and its strong margin growth, versus Procter and Gamble with its highly stable margins. The method we use to compare these different measures of margin strength is straightforward. We simply calculate the performance of the stock according to each variable expressed as its percentile in the universe of stocks, and use the maximum as our score. So, for example, Apple scores in the 93rd percentile for growth, and something lower for stability, so it scores a 93. Proctor and Gamble scores in the 97th percentile for stability, and something lower for growth, so it scores a 97. Note that high margin growth businesses are not penalized for lack of margin stability, and neither are high margin stability stock penalized for lack of growth. Our methodology has allowed us to directly compare Apple with Proctor and Gamble in overall margin strength, and to award the edge to Proctor and Gamble.

We have identified several quality metrics that can assist us in identifying the type of high quality businesses with wide economic moats favored by Warren Buffett. Since the existence of economic moats is often attended by strong profit margins and high returns on capital over long time frames, we look to some specific metrics that reflect these: long-term cash flow on assets, long-term return on assets, and long-term return on capital, as well as our margin strength measures which look for margin growth or stability. These unique points of measurement taken together can form a statistical canvas of quality metrics that provides us insight into the overall sustainability of margins, returns and earnings for any firm. If the metrics are sufficiently strong, we can be confident the firm has elements of an economic moat, indicating its quality.

Financial Strength

We will attack this next issue in Part 3b of our quality discussion, when we tackle financial strength…To Be Continued…