Top quality companies and how to decode their traits

If quality is about outperformance, or excess compounding, the next question is how do we identify it ahead of all the great returns? Morgan Stanly and Counterpoint Global have done some great papers on return on invested capital (ROIC) and how it relates to returns. The ROIC concept is essentially the after-tax return a company generates on its invested capital, which equipment, net working capital, intangibles such as goodwill, brand, software etc. The higher a company’s ROIC is the higher its equity valuation is, so this is a good starting point for discussing quality companies.

Because the economy is competitive the ROIC is mean-reverting which means that companies that are enjoying strong returns on invested capital will eventually meet strong competition and see its ROIC drift towards the average. In other words, investors should avoid buying a quality company that turns into an ordinary company. It is all about the ROIC transition.

As the table below shows, the worst stocks over a 3-year period are those that start as the best quality company (top quintile) and end as the worst quality. These companies experience -11% annualized returns over these three years. The best performing stocks are not surprisingly those that start as the worst companies and end as the best companies. These companies deliver 33% annualized returns. These exceptional transitions are difficult to predict. What is interesting is that those that start as the best and end as the best on ROIC deliver 20% annualized returns. Investors are essentially paid for enduring quality. If the company slip to the second best quintile they still deliver 7% annualized returns which is close to the market return.

Avoiding the quality to ordinary trap

As one can see from the table above between starting ROIC quintile and ending ROIC quintile over three years it is important to avoid investing in high quality companies that slip into being ordinary – essentially the value trap (buying a falling knife) just for quality companies. That is of course easier said than done, but are different filters investors can apply to reduce the probability of picking the wrong quality companies.

In our screening for high quality companies we set a minimum market cap of USD 10 billion to ensure we get companies of a certain size (often a marker of market reach and strong products). We also require minimum 15% ROIC which is a high threshold in a competitive market economy. Finally, we require total return over 5 years to be above that of the MSCI World. This is to ensure that we are looking at companies that have exceeded or lifted expectations above what the overall market did.

When you have a list of high quality companies the next step is to evaluate the durability of the business in order to be confident that it can remain a high quality company in the future. The “7 Powers” framework by Hamilton Helmer is a good reference for thinking about companies and whether they possess those characteristics of an enduring company.

US and European quality companies

Based on the screening criteria mentioned above we identified 10 high quality US companies all showing high ROIC and 5-year returns above the market. As the 12-month EV/EBITDA estimates show, high quality is expensive relative to the overall equity market. This is why maintaining the high quality over a longer period of time is so important for future returns. These companies are essentially fighting against high expectations. It is important to stress that the table does say anything about whether these companies have enduring quality, but just that they are quality today. Below we are highlighting some key points for why Apple and Nvidia are high quality companies.

Apple’s quality characteristics:

1. Robust financial health and profitability: Apple consistently demonstrates strong financial performance with substantial revenue and profit margins, backed by a diverse range of products and services that generate a stable cash flow. Its ability to maintain high profitability, even during economic downturns, highlights its operational efficiency and pricing power.
   
   
2. Innovative product ecosystem: Apple's ecosystem of products and services, including iPhones, iPads, Macs, Apple Watch, and services like Apple Music and iCloud, create a seamless and integrated experience for users. This ecosystem promotes high customer loyalty and repeat business, acting as a significant barrier to entry for competitors.
   
   
3. Brand strength and market position: Apple is one of the most recognizable and valuable brands in the world, known for its quality, design, and user experience. This brand strength allows it to command premium pricing for its products, contributing to its large market capitalization and appeal as an investment.

Nvidia’s quality characteristics:

1. Leadership in AI and GPUs: Nvidia is a leader in the graphics processing unit (GPU) market, which is crucial not just for gaming but increasingly for artificial intelligence (AI), data centers, and machine learning applications. Their cutting-edge technology and continuous innovation have kept them at the forefront of these rapidly growing industries.
   
   
2. Expanding market applications: Beyond gaming, Nvidia's technology powers a wide range of applications including autonomous vehicles, professional visualization, and cryptocurrency mining. This diversification helps buffer the company against downturns in any single sector and positions it to benefit from multiple growth trends.
   
   
3. Strong financial performance: Nvidia consistently demonstrates robust financial health, with impressive revenue growth, high profit margins, and strong cash flow generation. This financial stability, combined with its strategic investments in R&D and market expansion, makes it a favoured choice among investors looking for growth and stability in the tech sector.

The European top 10 on quality is listed below and shows companies from a wide range of industries. It is also worth noting that the 10 US companies listed above have an average 12-month EV/EBITDA of 24.2x which is significantly more than the average of the 10 European quality companies at 17.7x highlighting that companies are willing to pay a higher equity valuation for US companies than European. This is one of the reasons why we tactically like European equities more in Q2 than US companies. As with our description of quality characteristics for Apple and Nvidia, we have listed the three key characteristics for Novo Nordisk and ASML.

Novo Nordisk’s quality characteristics:

1. Leadership in diabetes care: Novo Nordisk holds a dominant position in the global diabetes market, renowned for its comprehensive portfolio of insulin and GLP-1 treatments. This specialization has enabled it to lead innovations in diabetic care, ensuring a steady demand for its products.
   
   
2. Expanding into obesity and other chronic diseases: Beyond diabetes, Novo Nordisk has been expanding its focus to include treatments for obesity and other serious chronic conditions. This diversification into new therapeutic areas offers additional revenue streams and taps into growing healthcare needs worldwide.
   
   
3. Strong financial performance and growth outlook: Novo Nordisk consistently shows robust financial health, characterized by strong revenue growth, high profit margins, and effective management of costs. The company's focus on research and development in biopharmaceuticals promises continued innovation, potentially leading to sustained long-term growth.

ASML’s quality characteristics:

1. Monopoly in advanced lithography technology: ASML is the sole supplier of extreme ultraviolet (EUV) lithography machines, which are crucial for manufacturing advanced semiconductor chips. This unique position effectively grants ASML a monopoly in this critical segment, securing its relevance and demand as chipmakers push toward smaller, more efficient chips.
   
   
2. Critical supplier to leading chipmakers: ASML’s customer base includes the world’s leading semiconductor companies, like TSMC, Intel, and Samsung. These companies rely on ASML’s photolithography equipment for chip production, underscoring its entrenched position in the semiconductor supply chain.
   
   
3. Strong financial health and investment in R&D: ASML exhibits robust financial performance with consistent revenue growth and high profit margins. The company's substantial investment in research and development ensures that it remains at the technological forefront, further solidifying its competitive edge and market leadership.

How to find quality companies

The global equity market is big and it can be difficult for retail investors to find the right quality companies. The best way is to find a screening tool that include the option to screen on ROIC and total return, and potentially other things such as net debt and interest coverage (you do not want a leveraged company). Another way of getting a starting list is to look at the holdings list of the largest global high quality ETF which is the iShares Edge MSCI World Quality Factor UCITS ETF. Under the holdings list you can download the entire fund holdings into a csv format and then work from there.

Why is quality companies important for the portfolio?

Recent notes on equities