Navigating investment styles – what is ‘quality’?

One such prominent investment style is quality investing, which focuses on evaluating companies based on key ‘quality’ characteristics. Unlike some other investment styles that may prioritise short-term gains, quality investing aims to identify financially robust companies that offer sustainable and attractive returns over the long-term.

In contrast to growth investing, which can lead to impressive but often volatile short-term gains, quality investing takes a more measured approach. It seeks out companies that demonstrate financial health, stability and consistent growth potential. This strategy relies on a blend of hard and soft criteria to assess a company's viability as a long-term investment. It’s important to note that quality companies do indeed fall into both the ‘growth’ and ‘value’ investment universe.  

Hard criteria – the quantitative metrics

The hard criteria in quality investing are primarily financial metrics that gauge a company's fiscal strength and stability. A few of these metrics include:

• Low debt: this indicates that a company isn't overburdened by debt, or reliant on borrowed cash; a sign of financial prudence
• Attractive cashflows: companies can appear to be growing through financial engineering whereastrue cashflow is hard to fake 
• Reinvestment of profits: successful reinvestment can trigger a cycle of growth, where prudent investments lead to enhanced efficiency, lower costs and increased cash flow, causing the compound growth of capital value over the long-term
• High return on capital: a high-quality business produces an attractive amount of profitability compared to the amount of money invested in that business
• Profitability: consistent profitability is a hallmark of a quality company, suggesting strong operational performance
• Wide margin: A company that makes a product for £10 then sells it for £20, is more attractive than a company that makes a product for £10, then sells it for £11.

Soft criteria – the more nuanced qualitative factors

In addition to financial metrics, quality investing considers qualitative factors that contribute to a company's overall sustainability and success. These soft criteria include:

• Management team: a stable and skilled management team with a clear vision and strategy is vital for long-term success
• Barriers to entry: companies with high barriers to entry can maintain their market-leading positions, indicating sustainable growth prospects
• Company culture: a strong company culture reduces turnover, retains experienced employees and contributes to long-term success
• Pricing power: the ability to raise prices without significant demand reduction demonstrates a strong competitive position and pricing power.

Pricing power is one of, if not the most, important characteristics of a quality business in our view. Companies with pricing power demonstrate a sustainable economic moat – durable competitive advantages that allow them to pass on costs to consumers without sacrificing market share. Brands that consumers rely on, and trust, often have the pricing power to maintain their customer base too – such as luxury goods companies. As an example, Microsoft Office is depended on by businesses globally for their operations. Microsoft is able to raise prices without triggering a significant switch to competitor products such as Google’s offering because they have significant pricing power.

Quality investing as a long-term strategy

In the face of market fluctuations and economic challenges, quality investing shines as a strategy that prioritises long-term stability and growth. The graph below shows quality investing in comparison to market weighted world stock markets over the long-term. 

Given all of the market uncertainty, quality companies offer the opportunity to provide strong returns in rising markets but also have the more defensive characteristics in down markets to weather the storm.