Quality, defined
October 2014
Search the Internet for “measures of investment quality” and you are likely to find roughly one-tenth as
many results as you would if you searched for “measures of investment return” or “measures of
investment risk.” Quality, it seems, is hard to define. Or maybe investors find the concept less
interesting than return and risk, therefore spurring fewer writers to their keyboards.
In any case, at Aberdeen we have always been intensely interested in
quality, preferring to concentrate our stock portfolios, for example, on
high-quality companies. We focus on high-quality companies because
we believe they deliver higher long-term returns than low-quality firms.
Across the investment management industry, however, definitions of
quality vary. Here we summarize the five aspects of quality we consider
most important when assessing companies for equity investments.
Industry traits
Business strategy and prospects
A few of the questions we consider in assessing industry traits are:
Before investing, we need to believe that the company’s business model
is durable. Toward that end, we seek evidence of industry growth, a clear
business strategy and solid execution of that strategy.
• Has the rate of industry growth been consistent or uneven, and what
are the industry’s prospects?
A few of the questions we consider in assessing business strategy and
prospects are:
• Is the industry highly competitive and fragmented or dominated by a
few companies?
• Is the company overly reliant on acquisitions to sustain growth?
• Does the company have a distinct value proposition that gives it
pricing power?
• Would we feel comfortable locking the stock in a box and not touching
it for five years, or would we worry about its impact on the portfolio?
1
oogle searches performed on September 2, 2014 found 126,000 results for
G
“measures of investment return” and 144,000 results for “measures of investment
risk” but just only 13,700 for “measures of investment quality.” Yahoo searches yielded
even more disparate results—16,000, 32,000 and 34, respectively.
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The industry in which a company operates is important. According to the
Global Industry Classification Standard established by MSCI and Standard
& Poor’s, there are 67 industries worldwide, ranging from aerospace and
defense to wireless telecommunication services. Industry characteristics
naturally vary. Some businesses are capital-intensive, while others are less
so. Some are difficult to enter, while others have low “barriers to entry.”
• What level of capital expenditures is required?
Management team
The motivation, experience and track record of the executives atop a
company are vital. In essence, we ask ourselves if we trust the individuals in
charge. If we do, we may invest. If we don’t, we will not invest.
A few of the questions we consider in assessing a management team are:
• Do they have the necessary backgrounds and capabilities to manage
the business?
• Is it a one-person show, or does the company have a deep pool of
management talent?
This conflict plays out all the time. CEOs leave office having earned
millions despite an underperforming share price. In theory (again)
codes exist to determine “best practice” in governance. A standard
recommendation is for a majority independent non-executive board of
directors to oversee managers on behalf of shareholders. Good corporate
governance boils down to a proper system of checks and balances and a
more subtle thing: trust.
A few of the questions we consider in assessing a company’s commitment
to shareholder value are:
• Have they done a good job allocating capital?
• Do independent board members have the power to influence the
direction of the company?
Balance sheet
• Are measures of executive performance aligned with the interests of
long-term shareholders?
Corporate profit reports tend to capture financial news headlines, but we
view a company’s balance sheet as a better gauge of its financial health.
The balance sheet provides a snapshot of a company’s assets, liabilities and
equity. Interpreted properly, balance sheet data can reveal how much debt
a company has, if customers are paying on time and whether the company
is investing its surplus cash wisely or allowing too much to sit idle.
As an investor, we feel much safer when a company offers a strong balance
sheet. A robust balance sheet usually means a firm has spare cash to fund
corporate expansion or to boost shareholder returns via share buybacks
and/or higher dividends. In contrast, a weak balance sheet, which may, for
example, reveal too much leverage, scares us. We typically define leverage
as either debt/equity or net debt/EBITDA.2
A few of the questions we consider in assessing a company’s financial
statements, including not only the balance sheet but the statement of cash
flows, are:
• Is the business over-leveraged?
• How variable is the cost structure and thus profit margins?
• Does the business generate free cash flow3 during both good and
bad times?
Commitment to shareholder value
For whom are companies run? In a public company the shareholders are
the owners. In theory, at least, the company is run for them. Yet almost
since the beginning of the joint stock company in the 19th century, it has
been recognized there is a flaw in the system.
• Does the company have classes of stocks with different voting rights?
In conclusion
“Our life is frittered away by detail,” wrote Henry David Thoreau.
“Simplify, simplify!”
At Aberdeen, we think the author of Walden was on to something.
We like simplicity. We like clear commitments to shareholder value,
easy-to-understand business strategies, plainspoken and trustworthy
management teams, strong balance sheets and well-governed
enterprises. We also favor companies with “visible” paths of probable
earnings—at least, relatively visible earnings, given the inherent ups
and downs of economic conditions and, in many cases, company
competitiveness.
Not every company will score well on every measure of quality, and
the weight we assign to each measure may differ from one industry
and company to the next. Judgment must trump dry process. Once we
have identified a high-quality company, we can proceed to questions of
valuation, recognizing that even the highest-quality business can make
for a poor investment if it is overpriced at purchase. But that is not the
end of it. The investigation of quality continues after we’ve invested.
Companies improve; they also lose their way. We know our screens are
working when we can spot those changes early.
When owners are passive shareholders and entrust management to
outsiders, problems of agency may occur. The manager, possessing
more information on the day-to-day business of the company, may
try to maximize his wealth at the expense of the owner, creating a
conflict of interest.
2
3
EBITDA is earnings before interest, taxes, depreciation and amortization. Net debt equals debt minus cash, cash equivalents and short-term investments.
Free cash flow is the amount of cash a company has after expenses, debt service, capital expenditures and dividends.
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Contact us
Maria Eugenia Cordova
(Florida)
Damian Zamudio
(New York & Southwest)
Andrea Ajila
(Advisor Services)
Regional Sales Manager
International Wealth Management, Americas
Aberdeen Asset Management Inc.
1395 Brickell Avenue, Suite 800
Miami, FL 33131
Mob:+1 917 710 3526
Fax:+1 212 776 1171
[email protected]
Regional Sales Manager
International Wealth Management, Americas
Aberdeen Asset Management Inc.
712 5th Avenue, 49th Floor
New York, NY 10019
Tel:+1 212 776 1182
Mob:+1 619 307-0919
Fax:+1 212 776 1171
[email protected]
Advisor Services Associate
International Wealth Management, Americas
Aberdeen Asset Management Inc.
712 5th Avenue, 49th Floor
New York, NY 10019
Tel:+1 212 776 1180
Mob:+1 203 898 5142
Fax:+1 212 776 1171
[email protected]
Website: offshore.aberdeen-asset.us/usoffshore
IMPORTANT INFORMATION
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
Equity stocks of small-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies. Foreign securities are more volatile, harder
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