The dictionary definition of quality is ‘the degree of excellence of something’. Handmade Hermes scarfs that use high quality silk would fit this description of quality. However, just because a company makes high quality products, it doesn’t necessarily mean that the business itself would be considered a quality business by investors.

This article looks at three different metrics which indicate quality from an investor standpoint. The goal is to help you understand ways of screening the market and become better at spotting winners for your investment portfolio.

1. RETURN ON TANGIBLE EQUITY

Return on tangible equity (ROE) is the net profits of a firm divided by the total shareholder equity, excluding intangible assets, such as goodwill, brands or software.

A return of 20% or better, sustained over many years and without the use of undue leverage would be considered a high quality company.

DOES SUPERIOR ROE PRODUCE SUPERIOR STOCK RETURNS?

A 1986 study by Fortune magazine looked at returns on equity for the largest 1,000 companies in the US by market value. Here are some interesting facts from that study:

– Only six of the 1,000 companies averaged over 30% ROE over the previous decade (1977-1986)

– Only 25 of the 1,000 companies averaged over 20% ROE and had no single year lower than 15% ROE

– These 25 business superstars were also stock market superstars as 24 out of 25 outperformed the S&P 500 index during the 1977-1986 period.

That last statistic is really quite remarkable, and bears repeating, 96% of companies which qualified went on to beat the toughest benchmark in the world.

2. GROSS PROFITS-TO-ASSETS RATIO

Gross profits are the revenues earned minus the direct cost of goods sold. It is the value-added part of a product or service, therefore it represents pricing power.

For this metric, we divide gross profits by the total assets employed. Total assets employed are sometimes referred to as the balance sheet total.

For example, in the 12 months to 30 March 2019 Burberry (BRBY) produced gross profits of nearly £1.9bn and it employed total assets of £2.3bn, giving a gross profits-to-assets ratio of 83%, a very high number. Any number over 70% indicates that you are looking at a high quality business.

Gross profits-to-assets is one of the purest metrics available in the sense that it cannot be easily manipulated by management, and it is simple to understand, unlike some ratios further down the income statement. There aren’t any companies that report ‘adjusted’ gross profits or total assets. It also means that comparing companies is straightforward.

DO HIGH GROSS PROFITS-TO-ASSETS RATIO COMPANIES PRODUCE SUPERIOR STOCK RETURNS?

Robert Novy-Marx, associate professor at University of Rochester, New York, ran an empirical study in 2013 on gross profits to total assets as a predictor of stock returns. He found that highly profitable companies significantly outperformed the benchmark and with much lower risk.

Interestingly, he discovered that deploying this metric in combination with value strategies was even more effective.

3. PIOTROSKI F-SCORE

Joseph Piotroski, associate professor of accounting at the Stanford University Graduate School of Business, developed the F-Score in 2000 while at the University of Chicago. He was interested in finding out if it were possible to weed out poor performers and winners, in advance, just from studying historical accounting data.

Piotroski set out to devise a checklist, comprised of nine different accounting measures, covering profitability, leverage and operating efficiency.

A company was awarded a point for each test that it passed. A score above 7 was considered to be a high quality company, while those scoring below 3 should be given a wide berth.

DOES THE F-SCORE WORK IN PRACTICE?

Empirical analysis to test out the strategy in the UK market seems to be very limited. However, Piotroski’s research in the US does suggest that this type of fundamental analysis can be an effective filter.

By investing in companies with a score greater than 7, over a 20-year test period, from 1976 to 1996, the mean return was 7.5% per year better than the market. This was equivalent to 4.2 times the S&P500 return.

Furthermore, Piotroski found that buying the top stocks in the market and betting against those with the worst scores (via short-selling) would have resulted in 23% annualised gains, more than double the S&P 500 return.

What you leave out is just as important as what you select, so it is impressive that weak stocks, scoring two points or less, were five times more likely to either go bankrupt or delist due to financial problems.

Anyone interested in following both parts of this strategy should note that short-selling is very high risk and you can lose more than you initially invest. Short-selling is not suitable for the majority of retail investors due to the risks involved.

OUR ULTIMATE SCREEN

We have shown that having high quality companies in a portfolio can be very lucrative. Just as important, it can remove potential losers from temptation, saving investors some potential headaches.

We decided to go one step further to see if any UK-listed companies could survive a combination of all three screens. This would surely be a stronger test of quality and provide a list of the crème-de-la-crème of quality stocks.

To recap, each candidate needs to meet the following criteria: have a five year average return on equity above 20%; have a gross profits to assets ratio of at least 75%; and an F-score of at least 7. We have excluded financial companies because there is no F-score for them and they report gross profits.

You can use financial websites such as Stockopedia and SharePad to help screen the market using the aforementioned criteria.

We are left with eight names: five consumer cyclicals, two industrials and a technology company. None of the stocks are what you would describe as classically cheap, but they have attributes which are hard to replicate and each display excellence in their chosen fields of expertise. There are also clear growth opportunities on offer.

HUNGRY FOR GREGGS

Food retailer Greggs (GRG) surprised the market again earlier this month, the fourth time that management have upgraded their expectations since November 2018. The company said that the strong start to 2019 had continued and it saw like-for-like sales up 11.1% in the 19 weeks to 11 May, an acceleration from the 9.6% seen in the first seven weeks.

The success is attributed to customer appetite for vegan-friendly sausage rolls. Once trading levels settle, the underlying like-for-like growth rate is likely to be much lower.

Greggs’ shares have probably moved ahead of the fundamentals, and we don’t believe the rating fully reflects the challenging conditions on the high street. The shares trade on 24 times current year earnings, at the top end of the historic range. This is a great business – simply wait to buy it at a more favourable price.

Also on the list is recruitment consultant PageGroup (PAGE) which is trading on a modest 14 times forecast earnings for the current year and has good growth opportunities, amid increasingly tight labour markets globally.

In the UK, the latest CIPD survey showed that 70% of all firms are ‘having difficulty’ hiring and 40% of vacancies are proving ‘hard to fill’. The likes of PageGroup should therefore be able to charge clients more to place suitable candidates into jobs. We rate the shares as a ‘buy’.

The business performance of home furnishings retailer Dunelm (DNLM) continues to blow the lights out, confounding the gloom and doom on the high street. In April it reported c10% like-for-like growth from the physical stores and 32% from online.

Despite highlighting political and economic uncertainties, the company guided towards the top end of expectations for full year pre-tax profit. The shares trade on 17 times forecast earnings for the year to June 2020, towards the top of the historical range. That looks too expensive to warrant buying at the moment.

BURBERRY’S APPEAL

Founded in 1856 Burberry is a distinctly British brand with broad appeal across the globe. The company has increased its revenues
and profits over the last few years, driven by increasing consumer wealth in emerging markets. Aspiring consumers in China, India
and South America seem happy to spend more of their disposable incomes on well-known Western brands.

We like that the company uses licensing partners in certain territories, like Japan, to distribute its products, because this is a capital-light way to reach more customers. It creates a long-term royalty stream, increasing returns on capital employed. Licensing revenue makes up around 20% of revenue.

Full year results published earlier this month flagged a ‘very encouraging’ reaction to designer Riccardo Tisci’s first collections and included a 3% dividend hike. The company said it would also buy back £150m of its shares.

This is an attractive feature of the business and continues the historic trend. Since 2018 it has returned £350m in cash through share buybacks, equivalent to 4.4% of the market value, in
addition to a 2.3% dividend yield. It’s unusual to find  growth and income on offer from a large, quality, global business.

However, recent tensions in US/China trade talks have created a short term headwind for Burberry and analysts have become more circumspect about its prospects. In addition, China’s growth has been showing increasing signs of slowing from the 6%-plus levels of recent years.

While it has the hallmarks of a decent business, anyone buying the stock today will need to be patient. Recent sales growth hasn’t been as good as expected so market sentiment may be weak towards the stock until it can provide evidence of stronger trading.

QUALITY SMALL CAP

The only small cap to make our final list is laser-guided equipment manufacturer Somero Enterprises (SOM:AIM). It delivered record revenue and profit for 2018, with revenues rising 10% to $94m and pre-tax profit up 13% to $29.1m. In addition, the company paid £12.3m in dividends. The company is upbeat about future prospects and sees healthy growth opportunities.

Somero has very little direct competition and its patents give some protection to its high returns and market position. It is noteworthy that penetration of China has been slow, perhaps reflecting a lower adoption of intellectual property rights. The shares trade on 11.4 times earnings, despite a solid growth record and high returns on equity.

We’ve been big fans of the company for a long time and have previously written about its attractions in Shares. Although this is a cyclical business, we do see merit in buying at the current price.

AND THE REST

Online fashion retailer Boohoo (BOO:AIM) delivered strong results for the year to 28 February 2019, with sales up 48% to £857m.

The medium-term guidance is for 25% annual sales growth with a 10% EBITDA (earnings before interest, tax, depreciation and amortisation) margin so it may be that the shares have already discounted a lot of the good news. This is a great business but the price looks too high at the moment, trading on 52 times forecast earnings for the year to February 2020.

Games Workshop (GAW) trades on 19.5 times earnings, at the upper end of the historical range. Its recent trading statement guided for £80m pre-tax profit for the year to 2 June 2019.

The company has a strong global brand in Warhammer and operates a simple and repeatable business model. The focus on fantasy miniatures provides almost unlimited scope for product innovation, which should drive future growth opportunities. We rate the stock as a ‘buy’ despite the high rating.

FDM (FDM) was one our recent Great Ideas selections, so it is reassuring that the screen identified the company as high quality.

It has significant growth opportunities both in the UK and overseas and we rate it as a superb stock to buy.

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