Picking high quality stocks is crucial for investment
Iuse this terminology “high quality” stocks quite often, in my writings. Some people have asked me whether I could be specific in defining or explaining what a “High Quality” (HQ) stock is.
Let me put across some characteristics of high quality stocks, as I imagine them to be.
LONGEVITY WITH PRICING POWER
In this era of technological change, life cycles of companies are shortening. So what define HQ stocks is a tough task. Many years ago, we used to talk of Nokia as a HQ stock. We thought it would last forever. Or Kodak. Even a mighty company like General Electric has metamorphised.
At the same time, we have companies like Unilever, P&G, Gillette, Cummins, 3M etc which seem to keep going on and on. They are in the same space and remain leaders in their industry. This leadership also brings with it a distinct edge in profitability. They are typically very profitable. Shareholder returns are the consistently high.
A company like Colgate India or Hindustan Unilever Ltd has enjoyed 100 per cent return on equity in many years. However, I like to put a number of 25 as the required ROE, consistently, over ten years at least. Maybe in financial services or banking, it is not likely that such high Return on Equity can be seen, because there is nothing special in what a bank offers vis-a-vis another. Banks will be lucky to earn over 15 per cent ROE consistently.
These companies deliver products or services of a quality that is demanded by the buyers, thereby enabling the companies to enjoy the power of pricing. These companies always pass on their cost increases. They constantly increase their profitability by lowering costs and maximising revenue.
LOW TO ZERO DEBT PRICING POWER
HQ companies will have no debt at all. In five to 10 years, these companies would become debt-free. Their profitability is high, working capital management is good and typically, their cash conversion cycles are low.
From buying raw materials to the point of selling and collecting their money, these companies have high efficiencies and do not keep throwing more and more money behind working capital.
Thus, we will not find companies in infrastructure, real estate, manufacture of heavy capital goods, shipbuilders etc with these HQ attributes.
These companies have a very long cash cycle and their profitability is generally not commensurate with the risks they take.
TAX PAYING
HQ companies will be generally paying tax at the marginal tax rates. This is because these companies have high asset turnover (a rupee of fixed asset generates many rupees of turnover in a year, unlike a ship builder or a infra company) and do not make investments simply to save tax. We see many promoters spend on unnecessary capital expenditure simply to lower tax.
DIVIDEND PAYING
All good companies should be paying dividend to shareholders. This is because of two reasons. One- cash is not needed by the business. And the second and more important reason is that keeping extra cash in bank simply lowers profitability. The business may earn 25% ROE and money in the bank will earn less than five percent post tax. We expect promoter/management to run a business and not to run a treasury.
CAPITAL ALLOCATION
HQ companies will pay out dividends. They remain focused on what they do. They will not simply diversify because there is cash.
As a shareholder, when you invest, say, in a two wheeler company, you do not want the management to get in to real estate. Many promoters have used cash in the books to invest in stock markets. These are poor quality companies. If promoters want to indulge in all this nonsense spends, they should buy out all the shareholders and do what they want. So long as even one share is held by the public, they should not be doing this.
If we take a short list of companies with the highest ROEs, with a cut off of, say, 25 per cent, we may not get more than 300 companies. And there will be not a single company from the financial sector or the banks.
The main reason why we invest is to ensure that the invested money earns the best possible return. We are not biased towards any one kind of business. We are looking at ‘sustainable’ growth with high Return on Equity.