The Quality of Companies: Practically all the value investors have gone down the same path of Buffett.

Graham was too focused on price at the expense of quality.  

However, in hindsight, it was clear that the portfolio of quality companies is the best approach to stand up to any market situations.

Indeed, past financial crises confirmed that high-quality companies at reasonable prices perform better over the long term than companies which are straight cheap.

Buffett invested in very underpriced real assets in the beginning of his investing career.   After partnering Charlie Munger, he focused on higher-quality stock, proxied by the degree of competitive advantage they enjoy.

Many investors have gone down this same path of Buffett, practically all the value investors.  The main reason is that it delivers better results over the long term, although there aren't many studies to back up this assertion, making it initially a far from obvious conclusion.



Why have practically all value investors followed Buffett, preferring quality companies?

Maybe, when they are young and start out investing, they have an excessive desire to do well and make their mark.  They tend to favour the cheapest companies, which on face value offer the greatest potential upside.

With experience and maturity, and after having stepped on a few booby and / or value traps (cheap companies in bad businesses, which languish for years, failing to create value) and their economic situation improves, their tastes tend to shift towards quality, even if they have to pay a bit more for it.

Business Quality

Business quality is defined by the return on capital employed, calculated before goodwill.

The implication is that better returns are synonymous with a better-quality business.

How do I take qualitative factors into consideration when using fundamental analysis?

Qualitative Factors in Fundamental Analysis

Fundamental analysis is the method of analyzing companies based on factors that affect their intrinsic value. There are two sides to this method: the quantitative and the qualitative. 

-   The quantitative side involves looking at factors that can be measured numerically, such as the company's assets, liabilities, cash flow, revenue and price-to-earnings ratio. 
-   The limitation of quantitative analysis, however, is that it does not capture the company's aspects or risks unmeasurable by a number - things like the value of an executive or the risks a company faces with legal issues. 
-   The analysis of these things is the other side of fundamental analysis: the qualitative side or non-number side.

Although relatively more difficult to analyze, the qualitative factors are an important part of a company. 

-  Since they are not measured by a number, they more represent an either negative or positive force affecting the company. 
-  But some of these qualitative factors will have more of an effect, and determining the extent of these effects is what is so challenging. 
-  To start, identify a set of qualitative factors and then decide which of these factors add value to the company, and which of these factors decrease value. 
-  Then determine their relative importance. 
-  The qualities you analyze can be categorized as having a positive effect, negative effect or minimal effect. 


The best way to incorporate qualitative analysis into your evaluation of a company is to do it once you have done the quantitative analysis. 

-  The conclusion you come to on the qualitative side can put your quantitative analysis into better perspective. 
-  If when looking at the company numbers you saw good reason to buy the company, but then found many negative qualities, you may want to think twice about buying. 
-   Negative qualities might include potential litigations, poor R and D prospects or a board full of insiders. 
-   The conclusions of your qualitative analysis either reconfirms or raise questions about the conclusions of your quantitative analysis. 

Fundamental analysis is not as simple as looking at numbers and computing ratios; it is also important to look at influences and qualities that do not have a number value.

Invest In Quality Not Quantity

June 15, 2012 

Tickers in this Article » HSY, BRKA, BRKB, KO, WDFC, HSY

Strangely enough, most investors commit a very basic mistake when they make investments. They choose quantity over quality. Psychologically, people find it very appealing to own 10,000 shares of a $1 stock versus 100 shares of a $100 stock. All the while, investors fail to forget that the size of pizza hasn't changed - it's merely 100 slices or 10,000 slices. The painful reality is that by choosing quantity over quality, the lack of quality increases the risk assumed, leading investors to sell at the first sign of trouble.

Keep It Simple
Warren Buffett, perhaps the world's most successful investor, has a unique ability to make very sophisticated investments that have created great value for his holding company Berkshire Hathaway (NYSE:BRK.A, BRK.B). Yet as Buffett will tell you, the most successful investments that created the greatest value for Berkshire were those where Buffett chose quality over quantity. Buffett made a huge investment in Coca-Cola (NYSE:KO) in the 1980s. The cost of that investment was roughly $1.3 billion. Today, that stake is worth around $14 billion. What that gain does not reflect are the dividends that Berkshire has received each year from its ownership in Coke. Berkshire owns about 9% of Coke's shares.

In 2011, Coke paid out $4.3 billion in dividends, $360 million of which went to Berkshire. Berkshire's biggest stock investments have been heavy on quality, as Buffett deeply values intangibles like brands, market leadership and durable businesses.

SEE: Think Like Warren Buffett

Boring Is Quality
At the end of the day, stock prices anchor on earnings growth. The highest quality companies are those with consistent records of profitability. Exciting industries can be profitable, but they invite lots of competition, which ultimately serves to erode profitability. Boring businesses don't invite competition and as such, can generally be counted on for generating consistent profits at an acceptable rate of growth. WD-40 (Nasdaq:WDFC) is a great example. The company makes a boring product that has been in use for decades.

However, the profits for WD-40 are anything but boring. Investors can count on around a 2.5% dividend yield each year. Same idea with The Hershey Company (NYSE:HSY). Candy doesn't change much and there is no fear of technology risk in chocolate. And people will always eat a little (maybe a lot) of candy. Therefore, it's no surprise that HSY has a return on equity (ROE) that would excite anyone: an ROE in excess of 70%. In today's zero percent interest rate environment, the 2.3% dividend is oh so sweet.

The Bottom Line
Investing benefits those who are patient and harms those who seek excitement. The passage of time allows for compounding to go to work, which is the greatest value creating force in investing. Investing in quality should be a starting point for all investors. 

http://www.investopedia.com/stock-analysis/2012/invest-in-quality-not-quantity-brk.a-ko-wdfc-hsy0615.aspx

How To Evaluate The Quality Of EPS and find out what it's telling you about a stock.

Examining Earnings Quality

Overview  

The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.

EPS Quality  

High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned.  A reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. 

1.  Positive earnings but negative Operating cash flow.

• The company can show a positive earnings on the income statement while also bearing a negative cash flow. 
• This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. 
• A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected.
• "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long.

2.  Operating cash flow > earnings 

• If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS.
• In this case, earnings are of a high quality because the company is generating more cash than is reported on the income statement. 
• Reported (GAAP) earnings, therefore, understate the profitability of the company.

3.  Operating cash flow < earnings

• If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. 
• In this case, EPS is of low quality because it does not reflect the negative operating results of the company.
• Therefore, it overstates what the true (cash) operating results. 

Trends Are Also Important

Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends.

• It is possible that an entire industry may generate negative operating cash flow due to cyclical causes.
• Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. 

• As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. 
• The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP EPS by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line

Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. 

Earnings increasing and Operating cash flow increasing > Earnings increasing but negative operating cash flow

The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. 

Operating cash flow > Earnings

The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. 

Positive Earnings but negative operating cash flow.

Luckily, it is relatively easy for investors to evaluate the situation. 

http://www.investopedia.com/articles/analyst/03/091703.asp

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.

A distinction between deep value and surface value. Deep value is independent of market price.

The term "investment value" refers to the concept of pure, true, intrinsic, economic value. 

• The phrase "expected investment value" refers to investment value adjusted for risk and uncertainty. 
• Economic valuation is the estimation of economic value.

Even with all these qualifying adjectives to clarify the meaning, the phrase is awkward and remains ambiguous. A less ambiguous distinction is between deep value and surface value. 


Deep value is investment value based primarily on intrinsic economic value estimated from expected future discounted cash flows and buttressed by accounting book value, quality and other aspects of value independent of market price. 

• Deep intrinsic value can include qualitative factors such as brand recognition, franchise, corporate governance, labor relations, government contracts and assets that are not usually marked to market. 
• A corporate governance score such as Standard & Poor's CGS [PDF or HTML] use criteria that may be indicators of long-term value creation, including both a Corporate Governance Score for a company and a separate Country Governance Classification for its country of origin. 
• The criteria are fairness, transparency, accountability and responsibility, as elaborated in Standard & Poor's Corporate Governance Scores: Criteria, Methodology and Definitions, July, 2002. 

Surface value is a misnomer -- it is not really value but rather market price, usually expressed as a ratio either with accounting items such as earnings, dividends, net worth, and sales, or with growth rate. 

• Surface value is analogous to unit pricing of fungible commodities by number, by volume, and by weight, for comparison shopping without regard to quality.

http://www.numeraire.com/value.htm

Wait for the Price to come to You (Timing versus Pricing)

Invest in businesses.  Recognise quality.  These are the factors that make a company great:

• it must have a good product,
• it must have a powerful competitive position and,
• it must have a strong management and culture that are open to change.

If you find all the above qualities together, you'll have a business that's making excellent returns on capital.

You should be able to confirm this by calculating that number from the accounts for the last few years, and checking how the cash is flowing through the business.

The next step is to work out the PE ratio that you'd be happy to pay for the business, or a dividend yield or a cash flow yield, or all three.

Then you wait, making adjustments to your valuation as needs dictate, so when the price comes into range, you'll be ready to pounce.

What to look for: Quality

Important attributes to look for in an earnings statement - QUALITY

As the market exerts ever-increasing pressure on companies to perform to a stringent set of expectations, the idea of accounting "stretch" enters the picture.

Even in complying with the rules, companies have latitude to apply accounting principles in ways that make performance look better.

This lattitude can affect the quality of earnings reports.

Recent legislation and standardizations like the Sarbanes-Oxley Act, have brought financial reporting generally more in line with reality.