Quality - Excellence Measured

Features, by Mark Robertson, Managing Partner July 27th, 2005

The quest of investors has always been a search for effective investment opportunities. At Manifest Investing, we believe that the search is for excellent companies at sufficiently-high projected annual rates of return.

Leadership companies with solid expected returns. The quest of investors has always been a search for effective investment opportunities. At Manifest Investing, we believe that the search is for excellent companies at sufficiently-high projected annual rates of return. Benjamin Graham believed that there was a direct connection between the quality of a company and its P/E ratio. The discussion that follows is my interpretation of long-term fundamental analysis and its role in portfolio design and management. The most important lesson that I’ve learned in over ten years of carefully studying (and practicing) long-term fundamental investing is that QUALITY MATTERS.

What is Quality? What is the role of quality in strategic long-term investing? Can we measure quality?

Quality is measurable and it can play a significant role in helping investors to avoid trouble. The time-honored path to success with strategic long-term investing is paved by understanding and respecting quality.

Quality. We all believe we know it when we see it. What’s it worth? www.investorwords.com has a powerful definition for “quality.” Quality is, quite simply, a measure of excellence. Excellence and respect are related. Excellent companies often exhibit consistent, credible growth and better results.

Quality is an important attribute as we build our sleep-at-night portfolios. Discovering leadership companies at the best prices necessarily means that we seek the quality leaders within their industries and accumulate them only when they go on sale. Implementation of strategic long-term investing over a lifetime means that we take advantage of opportunities to acquire the best of the best when it makes sense to do so.

Benjamin Graham On Quality

It must be important. Benjamin Graham was deeply troubled back in 1934. The antics and disasters of the late 1920s revolved around a lack of appreciation and respect for the fundamental quality characteristics of companies.

Monitoring the quality and projected return characteristics of all of the holdings in your portfolio is a valid approach to portfolio management. The long-term fundamentals and characteristics are continually monitored and the holdings with the lowest expected returns are candidates for potential replacement.

Graham reviewed “research” practices in place at the time and in 1934 wrote the first edition of Security Analysis. Authors Benjamin Graham and David Dodd dedicate a fair amount of attention to the subject and influence of quality on investments.

Benjamin Graham is widely regarded as the father of value investing and the text is universally used to teach fundamental analysis of common stocks. Graham is also known as Warren Buffett’s mentor and most significant influence. Graham said, “For the vast majority of common stocks, the average relationship between price and earnings will reflect the quality and growth of the issue.” I found it intriguing that Graham called out this relationship and sought a means to define it. In fact, Graham referred to the P/E ratio as the “coefficient of quality.”

Graham believed that there is a direct relationship between price, earnings (P/E ratios) and Quality. He noted, “a strong, successful, and promising company usually sells at a higher multiple than one that is less strong, less successful, and less promising…” Graham delineated the key influences on P/Es into two groups:

During our stock studies, we build expectations in the form of sales growth and profitability forecasts. When using the Value Line Investment Survey, we’re given a rating for EPS Predictability and Financial Strength.

I further believe that the intangible factors are covered when we perform an industry study. Why? Because industry studies generate some guidance with respect to relative sales growth and profitability by making comparisons.

Graham highlighted dividends as part of the quality overview. But this was during a time when 6-8 percent dividend yields were the norm. With today’s declining payout ratios, dividends are still important, but a less significant factor - and the influence of dividends has not been included in the quality rating calculation.

Quality is important. Ben Graham spent a lifetime of investment analysis seeking a reliable means of gauging it. If relative quality is important, and has a role in the realm of portfolio design and management, then we ought to seek means of measuring it.

Quality Ratings From Industry Studies

The accompanying table presents a profile of the Restaurant (Fast Food) industry. The average expected percent net margins, and forecasted 3-5 year sales growth are provided for the companies from the Value Line Investment Survey. The date of the company reports is June 10, 2005.

Fast Food Industry Study (6/10/2005.) A profile of fast food companies in order to compare growth and profitability characteristics. The industry leaders, based on these comparisons are Starbucks, Wendy’s,McDonald’s and Sonic Corp. Quality is MANIFEST Quality Rating (ranges from 0-to-100.) PAR: Projected Annual Return. Growth: Forecasted sales growth for the next 3-5 years. Sources: Manifest Investing, Value Line Investment Survey

As suggested in Graham’s work, part of the quality characteristic for any company is started by gauging the company’s position relative to its competitors with respect to growth and profitability.

The Quality Rating (QR) for any company ranges from 0-to-100. Based on the works of Graham, the 100-point scale includes four factors:

1. Relative Expected Sales Growth,
2. Relative Profitability,
3. Financial Strength and
4. Earnings Predictability.

We want to give equal weighting to each of these four factors because they seem fairly equally important to the overall representation of quality for a company. We want to score the relevance of a company’s growth and profitability outlook and give equal consideration to the company’s predictability (consistency and forecast confidence) and financial strength (balance sheet and competitive position.)

Therefore, the highest score that can be attributed to any one factor is 25.0. The scoring system is designed such that a company operating at the industry average would receive half of the available points for any one factor.

(1) Sales Growth Forecasts

The larger companies in the group are McDonald’s, Wendy’s and Yum Brands. The average expected sales growth rate for the Restaurants (Fast Food) industry is 8.6%. Note that the highest growth rates are 20.7% for Starbucks and 18.8% for Panera Bread. This is credible. Starbucks had higher growth rates and is now maturing with a moderating growth rate. Panera Bread is a relatively young company still experiencing geographic expansion.

We note that Wendy’s has a forecasted sales growth of 8.4% versus the industry average of 8.6%. Wendy’s should receive a sales comparison rating in the neighborhood of approximately 12.5. The math is actually (12.5)(8.4/8.6) = 12.2.

(2) Projected Profitability

The average profitability for the group is 7.7%, expressed in net margin. The profitability leaders are Sonic Corp. (14.8%) and McDonald’s (14.0%) after all these years of Happy Meals and Big Macs.

Continuing with Wendy’s, the projected net profit margin is 8.5% versus the industry average of 7.7%. Therefore, Wendy’s profitability comparison should be greater than 12.5 or (12.5)(8.5/7.7) = 13.8. We now have the first two parts of the quality rating.

Wendy’s – Value Line Ratings (6/10/2005.) The MANIFEST QualityRating uses two of the VL ratings as shown here. The Financial Strengthrating ranges from “C” to “A++”. The Earnings Predictability ranges from5-to-100. Source: Value Line Investment Survey

Studies of industries revealed some exceptions (e.g. Gentex) with growth rates or net margins that far exceeded their industry average. Depending on how comparison groups are chosen, some 50-60 companies within the Value Line universe of 1700 companies will fit this description. Gentex, when classified as an Auto Parts company, has a sales growth rate 3.5 times the industry average and a net margin that is nearly seven times more profitable. The intent is to limit the contribution of any single factor to 25 points. Again, a company operating at the industry average for sales growth would net 12.5 points, but the highest score permitted for any category is 25.0.

(3) Financial Strength

What goes into the Financial Strength rating for each individual company? Value Line defines Financial Strength as taking into account a lot of the same information used by the major credit rating agencies. The Value Line analysis focuses on net income, cash flow, the amount of debt outstanding, and the outlook for profits. Other factors are also considered. For example, a company that faces the loss of patent protection on a key product might face a downgrade. The ratings range from A++ (Highest) to C (Lowest) in nine steps, based on the judgment of Value Line senior staff members.

For the MANIFEST Quality Rating, the “academic grade” rating must be converted to a percentage. In the case of Wendy’s, their rating of “A” is converted to 80% and this component of Wendy’s QR becomes (0.80)(25.0) = 20.0.

(4) Earnings Predictability

This factor is actually a numerical score that reflects the straightness of the EPS historical trend. Value Line suggests that it becomes a measure of the reliability of an earnings forecast. I agree. EPS Predictability is based upon the stability of year-to-year comparisons, with recent years weighted more heavily than earlier years. The most reliable forecasts tend to be those with the highest rating (100); and the least reliable, the lowest (5). The earnings stability is statistically derived from the amount of fluctuations, or variations from a straight line. A straight line would generate an EPS Predictability of 100. For Wendy’s, the EPS Predictability is 100 (nearly a straight line) and the QR calculation becomes (1.00)(25) = 25.0.

Wendy’s – Overall Quality Rating

Add the four components to form the overall Quality Rating for Wendy’s:

Putting the Quality Rating in Context

Any index or ratio or rate is somewhat meaningless without a reference point. To establish reference points, nearly all of the companies within the Value Line standard edition were scored with the QR system.

The companies were ranked from highest to lowest quality ratings. The top twenty percent had a QR greater than 65.0. The next group, or 2nd twenty percent, had QRs between 55 and 65. The third quintile fell between 45 and 55. The bottom twenty percent (lowest quality ratings) were less than 35. The median, smack dab in the middle of the list, was 50.0.

But does it make sense? Does the Quality Rating reliably identify companies that would be likely to attract the attention of long-term investors?

The companies were profiled by industry and the following companies had the highest ratings within their groups:

This group of quality leaders suggests that the metric at least passes a test of common sense. Most long-term investors would agree that this list of companies would be among those that they regard with the highest perceptions of quality.

Summary and Conclusions

Quality matters.

My studies of successful long-term investors and their portfolios has suggested that the overall quality rating for their holdings tends to “hover” in the 65-75 range. Balance is always important in portfolio design and management and the successful seem inclined to maintain their quality levels at 70 or greater. This is particularly true during the late stages of bull markets, when projected annual returns (on average) are relatively low.

Do your best to grasp and understand the underlying principles. Attention is quickly drawn to the considerations of relative sales growth, profitability comparisons, financial strength and earnings forecast confidence.

The calculations are quick and with practice, can be done in a minute or two. As the accompanying Equity Analysis Guide to Long-term Expectations (EAGLE) for Wendy’s shows, the spreadsheet can make it easy to test your own assumptions and industry comparisons. And www.manifestinvesting.com delivers the current snapshot to you on demand with a few keystrokes.

Review this image as an Excel file.

And last but not least, Manifest Investing will often provide a chronological perspective on quality over time, often the trailing 10 years or more. As the accompanying graphic for Wendy’s shows, the quality strengthened starting in 1994 and has stabilized in recent years, maintaining an “excellent” quality rating for some time.

In summary, quality matters and the quality rating essentially becomes a “scored industry study” that is influenced by changes in internal fundamentals as well as the companies used for comparison. I believe that this is an important characteristic to monitor for our holdings and any potential candidates for our portfolios. Any deterioration should be taken seriously and prompt further study. Boost quality while bull markets rage and relax (to capture opportunity) when bear markets deliver the higher-growth candidates.

The quality rating does provide a frame of reference for comparing companies and a primary design characteristic for portfolios. Our holdings should exhibit a sufficiently high level of overall quality - a line of thought that I’m sure Benjamin Graham would have been most comfortable with.

Mark Robertson

Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.