There is endless data in the investment community on websites and blogs that discuss valuation techniques, the next latest buy or sell ideas and macro trends in the market. One area we find devoid of information for investors is the ability to understand and measure the quality of a firm’s management as well as the quality of a firm’s earnings in a meaningful way. While there are many different approaches to the valuation of a stock price, including our proprietary valuation model, there isn’t much information out there on measuring the Quality aspects of a firm.
AFG has developed some unique metrics that provide an objective approach to measuring management’s ability to create wealth for its shareholders as well as a firm’s ability to continue to generate solid and repeatable earnings that are an accurate representation of the company’s operations. We will set out to explain a little more in depth how we go about measuring the quality aspects of a firm from an unbiased perspective and also identify some High Quality companies from the S&P 500.
To gauge management’s ability to create wealth we first start by understanding if a firm is able to earn back its true economic cost of capital. AFGs Economic Margin metric helps clean up many of the distortions found in traditional accounting metrics to come to a more refined measure of profitability. Once we have a handle on whether the firm is truly profitable or not we then focus on the firm’s asset growth strategy in relation to its EM levels (profitability) to determine whether the firm is creating or destroying wealth for shareholders. Firms that are unable to earn back their cost of capital (negative EM) and continuing to grow are automatically flagged as potential “wealth destroyers”. We love to seek out positive EM firms that are also growing their assets to create the most wealth for shareholders. Firms with negative EMs are not necessarily “wealth destroyers” as long as the firm is focusing on improving profitability and divesting some of its losing parts. The last thing you want in your portfolio is a negative EM company that attempts to grow its assets, this strategy most often ends in pain for the shareholder.
Another way that we are able to assess the quality of a firm is to grade the quality of a firm’s earnings. Investors who count on future earnings performance, based on “creative accounting” techniques or blatant misrepresentations of earnings, are often caught with their pants down when companies in their portfolios encounter negative earnings surprises. We believe that A clear understanding of a firm’s accrual levels can give investors improved confidence in projections for the company’s future performance. The way that we grade the quality of earnings for a firm is by understanding accruals and flagging the firms with the highest levels of accruals as companies more likely to encounter negative earnings surprises and thus underperforming. This accrual based method of gauging Earnings Quality, pioneered by our good friend Richard Sloan, is an important tool in helping investors identify potential torpedoes in their portfolio. Accruals are the difference between Cash Flow and Net Income, essentially the percentage of net income which is owed to a company from their customers (accruals), to what they have already received in cash. Most investors like to see a company grow earnings, but it is vital that the earnings that are reported are an accurate representation of operations.
So….. AFG has an unbiased approach to grading Management and Earnings Quality. So What? Having a unique approach is only important if it adds significant alpha to your stock portfolios. So how much alpha does our Management Quality and Earnings Quality Grades add? The chart below highlights the performance achieved by both AFG Management Quality and Earnings Quality Grades over the past year within the Russell 1000 Index. The performance is from the AFG Investment Grade model, which separates groups of companies into quintile buckets, and attaches a letter grade of A through F. Although both variables added alpha to portfolios, Earnings Quality worked especially well as you can see in the 19% spread achieved between the A Grade and F Grade companies relative to the R1000 benchmark.
A pretty smart fella by the name of Warren Buffett has said numerous times that “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. We tend to agree with Mr. Buffett, and find that the Quality aspects of a firm often go overlooked or investors find themselves unable to gain any type of advantage in their own efforts to assess Management or Earnings Quality. Developing a focus list of “High Quality” companies and then refining your list based on which companies look most undervalued from a valuation point of view is a solid strategy for investors seeking long term investments in companies that are likely to outperform.
Taking a subjective thing like measuring quality and creating an unbiased and accurate approach that can give investors an edge is an extremely valuable tool to have. In the table below we have provided a list of firms from each economic sector that currently earn “A” Grade for Management Quality and Earnings Quality. These companies have maintained lower levels of accruals than their sector and index peers and are following a management strategy of wealth creation.
While we do not believe that every company on this list is currently attractively priced nor an attractive investment opportunity, this list can serve as a great starting point for investors looking for “High Quality” companies worth further investigation.
Russell 1000 – High Quality Focus List
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