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A Focus on Quality in the Midst of the Pandemic

S Rossi 2014
Stephen A. Rossi, MBA, CFA®, CFP®, ChFC®
Senior Vice President, Senior Equity Strategist
[email protected]
(585) 419-0670 x50677

Published on August 7, 2020 in the Rochester Business Journal

Now that we are in the midst of the COVID pandemic, there has been a lot of talk about the value of investing in high quality companies. The challenge is, what exactly does that mean, and how should one go about it? To answer these questions, several factors should be considered, including the consistency/quality of a company’s earnings, its ability to generate cash, and the strength of its balance sheet, among other things. Other factors, including a company’s relative position in its industry, and its management/corporate governance structure should also be considered. Cumulatively, these factors can paint a mosaic for an investor, helping to separate the strong companies from the weak, and the investable ideas from the speculative.

When we speak of earnings consistency, what we’re really talking about is a company’s ability to generate earnings on a year-over-year basis, as well as its ability to achieve a sustainable growth rate in earnings. Those that can consistently accomplish both are thought of as higher quality companies, as opposed to those whose earnings are inconsistent - or simply unpredictable. In terms of the quality of a company’s earnings, the focus should be on growing earnings organically, versus having to buy them via a merger/acquisition, or enhance them via a share buyback – all else equal, fewer shareholders means higher earnings per share. Recognizing that many line items on a company’s income statement can be manipulated or “financially engineered” to reflect a desired result, earnings consistency/quality should be just one of many factors considered, to identify companies that are truly best of breed.

An old college professor once told me to “follow the cash”. What he meant by this, is that cash doesn’t lie and that a study of a business’ cash flows can provide a window into the quality of its operation. Here, what we’re looking for is consistency/growth in operating cash flow and free cash flow. Operating cash flow reflects a company’s profitability (after adding back non-cash expenses like depreciation), how receivables and inventory are being converted to cash, and how payables are being managed to accelerate or slow down payments to vendors. Free cash flow takes this concept one step further, by adjusting available cash for necessary capital expenditures. Operating and free cash flow that continually trend higher are signs of a healthy, high-quality business. Decreasing and/or inconsistent operating and free cash flow can be a sign of trouble.

High quality companies typically have strong balance sheets that are both liquid and reasonably leveraged. Liquid simply means they have more assets that can be converted to cash in a year’s time (i.e. current assets) than obligations that are coming due in a year’s time (i.e. current liabilities). With high quality companies, the former typically exceeds the latter by a reasonable margin, basically indicating that a company has enough money to pay its bills. When we speak of leverage, we’re referring to a company’s use of debt (i.e. someone else’s money) to sustain its operation, as opposed to relying on its own capital. The use of some debt can be a good thing in business, as it’s often a cheaper source of funds than issuing shares of stock (i.e. equity, or ownership). This is particularly true, since debtholders don’t share in the ongoing profitability of a business. Here, high quality companies are those that make moderate use of debt versus its peers, but not so much debt that it would jeopardize the viability of the business, should it happen to fall on hard times. Remember, interest payments on debt are typically mandatory, while dividend payments to shareholders are almost always discretionary in nature. Having too many mandatory liabilities can reflect poorly on the quality of a company. Metrics that measure this leverage include long-term debt to equity, and total debt to total capitalization.

As for a company’s relative position in its industry, let’s just say the winners and losers have been fairly evident of late. Companies that have engaged in home delivery – be it food, merchandise, or personal services - have excelled. Those that provide online payment platforms and/or remote communication technologies have also done exceedingly well, while others that have continued to rely on brick and mortar locations have clearly lagged. In short, those that have adjusted their business models to “pivot” with the changing times have been perceived as higher quality companies and have seen their share prices rise. Those that have remained stagnant without the ability or willingness to adapt to the changing times have been perceived as lower quality companies and have seen their share prices fall.

Aside from a company’s relative position in its industry, the qualitative nature of its management/corporate governance structure is another area to take note of. Here, a broad and deep bench of leaders with years, if not decades, of experience is preferred. Companies that are transparent with their actions, that promote diversity within and across their organization, that have staggered board tenures, and that separate the roles of their Chairman and Chief Executive Officer are typically viewed as higher quality companies than those that don’t.

Choosing high quality companies to populate an investment portfolio can be subjective at times and is always a time-consuming endeavor. There is no one be-all or end-all factor that can help you with these decisions, but a focus on the factors contained herein can provide meaningful insight into how a company makes its money, what it does with its money, and how it manages its operation to remain viable. In the long-run, investing in high quality companies will never really hurt you. In fact, doing so can provide a portfolio with an added degree of stability, even in the midst of highly uncertain times.

To see this column in the RBJ, click here.

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