Robert Pirsig’s Zen and the Art of Motorcycle Maintenance posed philosophical questions about how to define “quality,” and the book serves as voluminous proof that the concept is not easily defined.
The investment community struggles in a similar fashion, although several academics and practitioners are taking steps toward identifying characteristics that define high-quality investments.
William Blair’s quantitative analysts addressed the issue several years ago. Realizing that mainstream metrics for defining quality had serious shortcomings that prevented their acceptance by our team of fundamental analysts and portfolio managers, our quantitative analysts worked with them to identify a better combination of metrics that aligned with our philosophical beliefs and helped our investment teams identify stocks that met our criteria for measuring quality.
In a previous post, we discuss in detail how we model quality and the importance of integrating what we call sustainable value creation.
How are our metrics different? In our view, the main shortcoming of mainstream metrics is that they tend to be influenced by accounting policies that can distort the analysis of quality. The metrics we use to determine quality instead emphasize cash flows.
We believe that focusing on a company’s cash flow generation improves the measurement of company quality.
Why Does This Problem Arise?
Many commonly accepted metrics for quality, such as return on equity (ROE) and return on assets (ROA), can be heavily influenced by accounting estimates and policy distortions.
For example, both use net income in the numerator, and net income is influenced by factors such as depreciation and amortization and accruals. These metrics have the potential to mask companies with true quality characteristics.
We believe that focusing on a company’s cash flow generation improves the measurement of company quality. Metrics that are incorporated into our measurement include cash flow return on invested capital (CFROIC) and free cash flow margin.
There are practical reasons that cash-flow-based metrics may improve the assessment of quality. For example, a company’s CFROIC measures the cash flows generated by the company’s operations divided by the total capital employed by the company. Theoretically, a company that produces strong CFROIC has options for what to do with the excess cash flow: that company can distribute the cash flow as a dividend, pay down debt, increase the solvency of its balance sheet, or reinvest into the business through capital expenditures.
The operative word used above is options. These companies have flexibility with how to use the cash flows they are generating beyond what their providers of capital demand. If and when market conditions become adverse, these companies can use these cash flows instead of being reliant on the markets to raise capital.
Demonstrating the Problem
Many investors define a quality company as one that has higher-than-average ROE and/or ROA. But, in the chart below, we identify a Japanese telecom company that, despite strong cash flow quality attributes, does not screen well using these traditional metrics.
This company’s quality looks better when incorporating metrics such as CFROIC, free cash flow margin, and gross profits to assets.
How Widespread Is This Phenomenon?
The graph below charts our proprietary approach to measuring quality against a traditional metric: ROE. The individual points represent individual stocks in the MSCI AC World ex U.S. IMI. We divided this chart into three regions:
- The area between the two yellow lines represents stocks where there is relative alignment between our approach to measuring quality and traditional metrics,
- The area above and left of the top yellow line represents stocks that the market perceives as low-quality but our approach identifies as high-quality, and
- The area below and right of the bottom yellow line represents stocks that the market perceives as high-quality but our approach identifies as low-quality.
While most stocks fall within the bands, there are hundreds of stocks where our approach and the traditional metric disagree.
Implications for Active Management
Quality is only one characteristic our Systematic team assesses; we also analyze and consider a stock’s valuation, the stock’s market sentiment, the stock’s liquidity profile, and how combinations of stocks can be integrated into a well-diversified portfolio.
Still, this analysis offers a couple of important implications about our approach to active management.
First, there are high-quality stocks that are underappreciated in the market. These are stocks that might be attractive candidates for portfolio inclusion.
Second, there are low-quality stocks that the market perceives as high-quality. Our approach seeks to avoid stocks like these in a wholesale fashion, and we believe this can help improve risk-adjusted performance over the long term.
Peter Carl is a portfolio manager on William Blair’s Systematic Equity team.
Investing involves risks, including the possible loss of principal. Equity securities may decline in value due to both real and perceived general market, economic, and industry conditions. Different investment styles may shift in and out of favor depending on market conditions. Any investment or strategy mentioned herein may not be suitable for every investor. The William Blair quality model combines measurements of sustainable value creation, earnings quality, and financial strength. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. William Blair may or may not own the securities referenced and, if such securities are owned, no representation is being made that they will continue to be held. It should not be assumed that any investment in the securities referenced was or will be profitable. Past performance is not indicative of future returns.
The Morgan Stanley Capital International (MSCI) All Country World Ex-U.S. IMI Index (net) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets, excluding the United States. This series approximates the minimum possible dividend reinvestment. The Index is unmanaged, does not incur fees or expenses, and cannot be invested in directly.