Today, I want to look at a specific investment strategy that’s capable of generating phenomenal long-term results. It’s a strategy that’s used by some of the world’s top investors, including Warren Buffett, Terry Smith, and Nick Train. I’m not talking about value investing, nor am I talking about growth investing. The strategy I’m referring to is known as ‘quality investing’.
This is the process of investing in high-quality companies that are able to generate consistent profits over a long period of time. It’s a unique strategy that focuses less on valuation ratios, such as the P/E ratio, and instead, focuses more on a company’s profitability, its financial strength and, most importantly, its consistency. The premise behind quality investing is that if you can find companies that can consistently generate high levels of profitability over time, shareholder wealth can be maximised.
It’s a strategy that clearly works, looking at the performance figures of investors that employ the strategy. For example, Terry Smith’s global fund Fundsmith has returned around 19% per year since its inception in 2010, which is a fantastic result. Similarly, Nick Train’s UK equity fund has returned almost three times the FTSE All-Share return since its debut in 2006. As for Warren Buffett, had you invested £1,000 with the legendary investor back in 1964, it would have been worth somewhere around £24m by last year!
So what does a high-quality company look like? Well, for starters, they’re able to generate high levels of profitability. They’ll have strong profit margins and they’ll also sport high return on equity (ROE) and high return on capital employed (ROCE) figures. This means that they’re very effective at generating profits. Often, this profitability is the result of a competitive advantage, such as a strong brand.
High-quality companies also demonstrate consistency. These companies can generate profits throughout the economic cycle, and that means they offer protection during market downturns. High-quality companies will often have strong, uninterrupted long-term dividend growth track records, which is another big plus.
Finally, high-quality companies also have financial strength. This means low debt, high interest coverage, strong cash flows, and ample liquidity. Again, this means that they’re less vulnerable during downturns.
In terms of some examples of high-quality companies, there are a number of these kinds of stocks in the FTSE 100. Unilever and Diageo could both be classified as high-quality stocks, in my view, as they both have strong long-term track records of growing their revenues, earnings, and dividends over time. Both are top holdings in Nick Train’s UK portfolio. Similarly, Reckitt Benckiser, which is one of Terry Smith’s top holdings, is another FTSE 100 stock that’s often classified as high-quality. Looking internationally, a glance at Warren Buffett’s portfolio reveals a number of other stocks that could be classified as high-quality, such as Apple, Kraft Heinz, and The Coca-Cola Co.
The thing to understand about high-quality stocks is that they usually don’t trade cheaply. It’s unlikely you’ll pick up a stock like Unilever on a P/E ratio of 10. However, quite often in investing you get what you pay for. So it can be worth paying a little extra for high-quality companies that can consistently generate strong results for you.
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Edward Sheldon owns shares in Unilever, Diageo and Apple. The Motley Fool UK owns shares of and has recommended Apple and Unilever. The Motley Fool UK has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.