How to Select High Quality Companies for Investment

We have now introduced our methodology for investing and explained why we want to go for high quality companies with sustainable high returns on capital.  Depending on your level of expertise and desired effort, you should select from index investing (lowest effort), dividend growth investing (moderate effort), and star list investing – investing from your developed shopping list of high quality companies (highest effort).

Given that we are going to focus on earning superior returns to indexing and that we desire to invest in high quality companies for reasons I outlined previously, we need to explore what makes a high quality company.  At its most basic level, a high quality company is one that can earn sustainably high returns on capital, year after year.  This means that the company will have pricing power as well as a “moat”, as Warren Buffett calls it, around the castle fortress to protect it.  It also means that the business is able to stick around for the long term.  That is, it can maintain its cash generating engine with the cash it generates from doing business, and that it is able to pay its debts easily with the cash it generates.

We are going to discuss how to identify all of these traits using some common financial measures, but first a word on these various financial measures.  No single financial measure ever tells the complete story.  You have to use them all together to learn to read the story of the company’s underlying economic engine.  Some people screen for stocks based on single measures, and that is ok.  But change up your measures, to get different looks at different slices of companies.  One company may have a high return on capital but be in a declining industry where those returns on capital will not be maintained.  Another company may have a negative shareholders equity (negative price to book value) and be considered to be a bad investment.  But this company may be the exception where debt lenders are foolish enough to provide all of the capital for the enterprise at attractive rates, while investors do not have to provide any capital, all while the underlying business generates so much cash that it can pay the debts off easily and shower the investors in cash.

Context matters.  We saw this with the shortcomings to the Fama and French model which looks at a single measure for determining the value factor for a stock – price to book.  This model cannot distinguish between value traps and truly low valued, but good companies because it uses a singular measure with no context.  It is a similar problem in value weighted index funds and other such endeavors.  There is far too much data to sift through, so the index fund or the model developer uses a shorthand for value, quality, or other factors of interest.  We don’t have to do that, however.  We can screen and use curated lists of quality (like the Dividend Champions and contenders), to further narrow our focus onto the few quality companies out of the tens of thousands of companies in the public investing universe.  We can then delve into a substantially smaller set of companies to understand the details and the context.

Back to assessing the quality of a stock, we are first going to look at the economic engine of the business.  We want to develop a shopping list of high quality stocks first, so we will select companies with great economic engines under the hood, regardless of current valuation. Valuation comes in later when we buy from the list based on good value once we have developed our pre-qualified shopping list of high quality stocks.  We want sustainable high returns on capital and a company that is in a good position to survive for a very long time, ideally we expect the company to last beyond the next 100 years.  Our track record won’t be perfect, but we aim to be much better than a randomly selected list of stocks.  So, first we download the latest annual report from the company’s investor relations website or the SEC EDGAR website.  The report you are looking for is 10-k (which is just the label the SEC uses to denote an annual report).  Here is a list of things that I look for in a great stock in terms of quantitative factors:

1. What is the long term average return on capital?  Is it rising or falling?  If you invest in high return on capital businesses your returns will tend to converge to the returns on capital (for unlevered businesses) over time, so invest in outstanding businesses that can maintain this.
2. What is the gross margin?  Gross margin = (revenue – cost of goods sold) / revenue.  I like this measure because it is less subject to manipulation than earnings based measures.  Basically, the only way someone manipulates this is through outright fraud (like faking sales) for which they have no cover from going to prison if it is found out.  Warren Buffett has said that if you have a company with a gross margin above 40%, you have probably found a company with a durable competitive advantage.  I like to screen for companies with gross margins above 20% and sift through the results.  Be aware that service based businesses may have high gross margins because their product is a service and labor costs from marketers, account servicing agents, etc. may be a large component of their costs.  If these costs are not involved in the direct labor for making a product, they will not show up as impacting gross margin.  Like all measures, gross margin isn’t perfect, but I like it a lot.
3. What is the company’s profit margin?  I like to see profit margins above15-20% but will sometimes let this go as low as 6-7% for special cases.  However, this measure needs deeper analysis to understand what the true profit margin is.  The one you see on a screener is often not a very good measure due to various earnings issues that must be adjusted / corrected first.
4. What is the company’s operating cash flow relative to capital expenditures on average?  As a first pass, I usually look at 3 year median operating cash flow to 3 year median capital expenditure, because I can eyeball this really quickly from the latest annual report.  To calculate the median of the last 3 years, just take the middle number of the 3 in each case.  I like businesses where capex is less than 1/2 of operating cash flow, and I very much prefer businesses where it is less than 1/3 of operating cash flow in most cases.  This means the business is a cash generating machine that is able to shower its owners with share buybacks, dividends, and reinvestment into high growth areas rather than spending every penny just to maintain the equipment to stay in business.  In most cases, this is a very important measure.  There are a very few businesses where I will relax this measure though – businesses that are usually very high entry barrier, de facto monopoly type businesses (think railroads and the like).  
5. What does the company’s operating cash flow and operating earnings look like relative to debt and relative to interest paid?  I like to use operating earnings because I want to know how well the underlying economic engine of the company can repay the debt, and not just using some one time sale of company real estate that has nothing to do with the underlying business.  So, I use operating earnings (usually a 3 year median operating earnings, because I can eyeball it on the annual report quickly and it removes the effects of a single outlier good or bad year).  I do the same with operating cash flow, because I want to know that the company has cash flowing into its coffers in sufficient quantities to service the debt.  For debt, I usually use long and short term debt net of cash and liquid cash like instruments (such as marketable securities).  I generally like to see debt that could be repaid in <5 years or <10 years if all operating earnings or operating cash flow were diverted to repaying the debt.  Sometimes, for a truly outstanding business on other measures, I will let this stretch maybe to 15 years, but not often.  I also break down debt by short and long term.  If there is a huge chunk of debt coming due and cashflow cannot cover it, this could be a problem.  I want to see that the interest on the debt is easily serviced by operating earnings and cash flows also.  It can be a problem even if all your debt is smallish, say 5x your cash flow, and it is coming due this year, and you have no ability to refinance it at attractive rates.  Usually, I also like to see operating earnings and operating cash flow >3-5 times the interest payment, but sometimes for truly great or fast growing businesses that have everything going for them I let this flex down as low as 2x (not that often though).
6. Is the company’s operating earnings, earnings, and operating cash flow vastly different, or similar to each other?  If earnings and cash flow are only a little different, its not a big deal.  It depends on the nature of the business but 10-30% difference is usually what is meant here.  But if earnings are 10x cash flows (particularly if this happens year after year and is not just isolated to 1 or 2 years), then I want to know why, and I will dig into the details to find this out.  Earnings manipulation, intentional or not, is problematic if it is occurring.
7. Does the company usually have positive free cash flow?  The best businesses will deliver consistent cash flow and profits year after year.  We are not looking for startups and pre-revenue companies.  We are looking for high quality businesses with established business models.  It’s ok to have a year or two of negative cash flows if the reasons are known and acceptable.  It is even ok to run negative cash flows, if, for example, the business sees a major new opportunity well within their area of expertise.  This new opportunity will require capital investments to establish and grow.  The new opportunity shouldn’t be so far out that the market or profitability is completely unknown though.
8. Does the company pay dividends?  If not, that’s ok, but if they do, are they consistent or growing on a total basis or a per share basis?  What is the payout ratio?  If a company really doesn’t have the cash available to pay dividends, no amount of earnings manipulation or fraud will mask this fact (eventually).  If the company is consistently paying out more than they are taking in, their payout ratio will be above 100% and they will eventually deplete the company of cash and need to take on more debt.  Companies in shrinking industries can often buy back their shares faster than the loss in revenue if they are cash generating machines.  On a per share basis, this means you own more of the company, more dividends, and more cash flow year after year, making you more money despite the fact that the company’s revenue is falling, so also consider per share measures for these kinds of companies.  Keep in mind that in the US dividend cuts are considered more undesirable, so US companies will try to keep the dividend at the same level or increase it, while avoiding cuts unless it is absolutely necessary.  European companies, on the other hand, tend to look at the results for the year and announce the dividend based on those, so the dividend can fluctuate from quarter to quarter.  This is perfectly acceptable, it is just a different norm that you have to be aware of.  You will find great companies in Europe that do not ever make the Dividend Achievers list (companies that have raised the dividend every year for at least 25 years), despite them being wonderful businesses.
9. What do the company’s industry specific measures say?  Various measures make sense to evaluate for different industries.  For banks it can be important to look at interest margin and tier 1 capital ratio.  For supermarkets and other inventory heavy businesses it can be important to compare inventory turns and days sales outstanding between years to understand if changes are happening for better or worse.
10. How does the company compare to competitors?  Of course I always like companies that are monopoly-like in their niche, but most will have some kind of competition.  Identify the competitors and analyze their businesses alongside each other.  What does the comparison look like?  For example, Exxon may have the lowest cost per barrel of oil extracted of all the oil majors, so they can be profitable when oil prices are low while the others run into difficulties turning a profit.
11. Many small things that are difficult to enumerate but come with experience – what do these say?  For example, are share counts increasing or decreasing consistently – In and of itself, this is neither bad or good.  However, if, for example, I am aware that the company I am analyzing is in a high growth market, and is issuing shares to grow, that could be a good thing.  If shares are growing because management is overly generous with compensation, but not delivering value in terms of making the business better, then that is a warning sign.  Similarly, the company might announce a huge share buyback.  That could be good if overall share count is actually reduced and the company is currently very undervalued.  In that case, share buybacks would be accretive to shareholder value.  If management is issuing equal or larger amounts of shares for executive compensation, such that the share count is still increasing even with the big buyback, then the share buyback could just be a way to subsidize management while making the company leaders look good by announcing a buyback that doesn’t actually help shareholders.  Similarly, if the company is objectively overvalued, it would be foolish to repurchase shares, since the company would be destroying shareholder value by doing so.

Those are some of the big quantitative factors that I look for in a quick initial screening of companies to determine if they are worthy of deeper analysis.  Next, we will turn to the qualtitative factors that I look for as I screen businesses for my star list of forever holdings.  Some qualitative factors include:

1. Can I easily understand how the company makes money?  If I read their annual report does it look confusing and deliberately misleading or is it very straightforward.  As an example GE’s annual reports up until it got into major financial troubles were always very confusing, not straightforward, and introduced strange custom management measures for how they were doing.
2. What is the nature of the industry that the company is in?  This one requires that you build up knowledge over time of how industries are and how they work.  Is it going to be in an industry where there are very high potential liabilities?  Is it in a declining industry?  Is it in an industry where new competition is moving in, and the company’s return on capital will necessarily decline over the next few years?
3. What is your impression of the company’s management?  Are they wasting shareholder value on vain acquisitions or excessive executive compensation?  Are they outstanding operators?  Do they take a long term view, protecting and nurturing the company’s moat and return on capital? Or do they sacrifice the future for short term goals? A company with great management can potentially push them up on your assessment.  However, beware of one caveat here.  Managements turn over with time.  People leave or get old and die and must be refreshed with new management eventually.  You don’t have a guarantee that new management will be as good.  In Warren Buffett’s words, “I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
4. What risks do you see for the company?  Is it in an industry where there are existential risks?  What lawsuits is the company currently fighting?  Is it just one or two lawsuits or many and a constant factor in running the business?  For example, PFAS (perfluoroalkyl chemicals) liabilities may be the next asbestos sized liability in the chemicals industry leading to the destruction of several companies.  Or they may escape, and the insurance companies take the hit.  Or they may both escape altogether with losses that they can manage.  Is the industry that the company is in going away permanently (think Buggy whips for horse drawn carriages after the invention and wide adoption of automobiles)?  Look for risks outside of the narrow window of what the company does.  Is the company entirely situated in Florida on the beach where a hurricane could wipe out its production facility?  Are they adequately insured against this?  Do they depend on a single supplier for a key piece of their product?  Read the risks statement in the annual report where management outlines the risks that they see, and branch out from there.
5. Can I easily understand how and why the company has a durable and maintainable high return on capital?  Is it a de-facto monopoly because it has rights of way in a region like a railroad or because it is a pharmaceutical company that enjoys exclusivity for 20 years due to government issued patents?  Does it have a recognizable name brand or product that cannot be duplicated, or is it an undifferentiated product like a steel beam or a life insurance policy?  Does it have some secret sauce or operate in a niche that competitors don’t access because they can’t or don’t want to.  Are there other barriers to entry?  Be aware that high regulation and high cost can be barriers to entry, but these can sometimes be overcome by large players depending on the size.  If it would cost $1 trillion to overcome the barrier, then the company is probably safe.  If it would cost $10 billion, this may not be insurmountable for a large player to enter the space.  Is it in an industry that traditionally enjoys high or low returns on capital?  Alcohol and tobacco, for example, have enjoyed high returns on capital for multiple centuries.  Will the government move in to regulate the industry?  Social media platforms have shown the ability to exacerbate or cause some social issues at scale, so will the government clamp down on these?  Are there network effects?  Social media platforms enjoy monopoly or oligopoly like characteristics.  Everyone uses Twitter/X, Facebook, Instagram, etc., because that’s what everyone else uses.  To break into the space, new players have generally needed a different model (for example Twitter’s model for short quick tweets vs. full posts for Facebook).  It can be hard to break into the space and take market share or users from existing platforms without a lot of funding behind it.
6. What does management’s discussion of the business say?  Read it in the annual report.  Is it easily understandable?  Are they calling anything out as being significant, and do you assess this as a future problem or advantage?
7. How does the company sit relative to competitors?  Are they better for some reason or worse?  Are they in a niche?  Do they all play nice or are they falling into a price war that will destroy everyone’s return on capital?  Is one player ramping up ad spending necessitating the others do the same and increasing costs for everyone?
8. How long has it been around?  Is it something relatively new, or is it very old and has a long history of making money?  Is it in a tried and true high return on capital industry like alcohol and tobacco, or is it something totally new and still unproven, like self-driving cars.  Keep in mind for the unproven stuff, it could be very valuable to society, but none of that value might accrue to the company.  For example, it might be the case that battery powered cars make enormous profits for Tesla.  Or it could be that the field becomes so crowded with other players, that none of them make much money despite the battery powered car delivering enormous benefit to society.  One example of this is steel mills – enormous benefit to society, but steel mills go broke all the time because they barely scrape by and none of that benefit accrues to them.
9. Are there any exogenous factors that need to be considered?  The company should be situated in and have operations in countries where respect for rule of law and property rights are strong.  For example, many Latin American countries have no problems confiscating property when political regimes deem it convenient.  Others reduce rights for foreign investors.  For others, bribery is the norm for doing business.  You want to avoid investing in companies who have significant operations in these countries.  It can be a major drag on returns in some cases, and in others can threaten the very exisitence of the company or the shareholder’s stake in the company. Countries and territories where there is constant threat of war or invasion should also be avoided.  Does the company have all of its operations in a region where earthquakes or Tsunamis happen?
10. Anything else that stands out in your mind and should be investigated further?  Some things will stand out to you that are particular to the company and situation.  Keep in mind though, our brains tend to discount information we don’t understand as less important, so make sure you don’t fall into that trap.  There is also the problem of “unknown unknowns”.  That is, things you don’t even know that you don’t know.  Things that are problems but that you are completely unaware of.  For example, there are always startup companies that are going to change the future based on a technology that cannot possibly work according to existing laws of physics.  One company was going to make a supercapacitor that could hold as much energy as a battery, not realizing that the dielectric material saturates at high voltages and cannot polarize any further, limiting the amount of energy a capacitor can store to an amount much lower than what they were predicting.  Every few years someone reinvents the horizontal wind turbine which will be “much lower cost” because it doesn’t need to sit up on a huge tower.  They base their design for this wind turbine off of the drag force and not the lift force, where the equations of fluid motion and energy prove that the drag force can never extract even half the energy that the lift force can from the wind.  Now, you don’t have to understand anything I just said with these 2 examples, but these are examples where you have unknown unknowns in investing.  Even the people who were supposed to understand this – the researchers and company founders overlooked these issues.  So, don’t invest in something you don’t understand.  Especially newfangled and unproven technology where you are not an expert.  Or do so if you must, but limit it to a small allocation from your portfolio, and diversify across many different assets to compensate for your ignorance.

That is an overview of some of the qualitative factors I assess in a quick first pass over the companies that I am investigating for my star list.  Combined with the quantitative factors, these measures allow me to screen my companies down to a short list to do detailed deep dive investigations of the remaining.  Usually, I do a non-restrictive computer screen using single factors or a very few factors like return on capital or gross margin.  I then combine these lists and do this initial screening using numbers in the annual report and the qualitative assessment.  I find that this assessment cuts down the number of companies substantially to a very short list to analyze in detail.

If you do this right, you should be picking only the highest quality stocks which is a small fraction of the universe of publicly traded companies.  To give you an idea, our star list has about 100 stocks out of a universe of over 30,000 publicly traded companies.  And this is after years of us scouring the universe of stocks in as many different ways as we can think to find hidden gems.  It is an ongoing process, too.  we continue to look.  Sometimes, you will learn things that necessitate that you remove one of the companies from your list that was previously included also.  You should have a good reason to do this, but it is an acceptable and necessary practice as you learn and grow.

If you didn’t understand all of the financial stuff I was talking about in this post, don’t worry.  We will cover these things in various future posts multiple times, so eventually, you will start to become familiar with how these financial measures work.  If you did understand this stuff, then great! You can start working at building a star list of companies.  Remember, though, at this stage you do the analysis independent of the value that the company is trading in the market.  You want to have a list of pre-qualified stocks that are of outstanding high quality, and be ready to pounce when one of them goes on sale.  Usually, there are several that are on sale at any given time, so you can take your monthly savings, dividends, and other money that comes in and invest regularly in the most undervalued companies on your star list.  We will cover good methods to track the valuation of these companies in a future post.