In days of yore, an impressive listed company might have been described as “blue chip”. Now the modern equivalents are more likely to be characterised as “quality” companies.
ZebraGPT, when asked why “blue” and why “chip”, answered in summary that “the term ‘blue chip’ symbolises high-quality, stable investments, drawn from the prestigious connotation of blue poker chips, which represent the highest value in the game.
“This term emphasises the reliability and strength of the companies classified as blue-chip stocks, making them preferred choices for investors seeking stability and long-term growth.”
“Blue chip” and “quality” are cut from the same cloth.
Fund managers with a focus on “quality” will be compared in performance with their rivals applying a different style of investing, with perhaps a focus on “value” or “growth” stocks designed to outperform portfolios with a quality bias and also outperform the wider stock market.
How should a quality company be identified? A variety of index constructors and ratings agencies select “quality” companies and combinations of them to inform investors. The accompanying table indicates the criteria adopted by four of these different agencies. As may be seen, there is much common ground, and the correlations between the different indices and their movements are high.
How would an enterprise qualify as a quality business — or hope to do so? That is, to evolve as a large, successful and valuable business with predictable growth in profits and a strong balance sheet that is expected to ensure its survival through good and not-so-good economic times.
Simply put, such success must be achieved through consistently successful allocations of capital by the business. A successful “quality” firm will have invested capital in projects, people, systems, marketing, knowledge and culture that provide good returns. If the growth in its bottom line exceeds the opportunity cost of the capital employed by the firm, it will have every incentive to scale up its offers to customers, investing more capital to grow its top revenue line and its earnings.
Such positive returns on shareholder capital will then generate the extra cash required to fund its growth from its own operations — from its own savings reinvested in the business. The higher the cash content of its bottom lines, the less accounting noise, the easier it will be to grow without additional debt or raising fresh equity, convincing actual and potential shareholders of its quality.
That is the predictability and sustainability of its business model. Organic growth, doing more of the successful same, perhaps with smallish bolt-on acquisitions of similar or complementary operations, is to be preferred to growth through mergers or acquisitions, which could prove to be large, expensive wastes of capital.
Investing in the intangibles, in employees and marketing, and in innovation through targeted research & development may also have become an increasing proportion of the extra capital employed as production and sales become more knowledge-based and data-based. If so, adding such expenses to the balance sheet and amortising them realistically on the income statement will better reflect the true nature of the modern enterprise and its long-term prospects. This is more so than conventional accounting, which treats such investment as an earnings-reducing expense, ignoring the potential long-term benefits of such allocations of capital.
A mixture of returns that beat the cost of capital and a willingness to allocate extra capital for growth that facilitates growth is a true measure of quality and the source of value-add for its shareholders. More so than simply realising high returns on capital without continuously investing for growth.
Investing in the quality index as constructed by MSCI since 2000 has, however, given superior returns for similar risks when compared with the MSCI value and growth indices. A $100 invested in the quality index in 2000 has grown to more than $800, while the same amount in the world market index would have grown to about $530.
In 2000-25 the returns on the MSCI world index averaged 0.61% a month, with a standard deviation of 4.45%, compared with 0.73% a month for the quality index for less volatility (standard deviation of 3.47%). The MSCI growth index realised a market-beating average 0.65% a month, with more risk on average (4.75%) and the value index achieved a below-market return of 0.56% (4.5%).
The superior returns from quality began in 2009 and have continued over most years since. Though this year to November quality has underperformed the world market by about 4%. Correctly timing entry or exit from quality, value or growth will remain a temptation.
Is the better long-term return for less risk from investing in a quality index explained more by consistent improvements in the quality of the average quality stock than just the benefits of quality — which would always perhaps command a premium price?
A quality company today has arguably become absolutely superior to one of 25 years ago and therefore more valuable on its improved merits. Or quality has improved in a surprising way, encouraging investors to bid up the value of a quality company.
Quality has improved perhaps because managing return on capital — tangible and non-tangible — is the new religion for managers.
• Kantor is head of the research institute, and Evans an analyst, at Investec Wealth & Investment. They write in their personal capacities.
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