Seven high-quality large caps

Both the confusion and answer lie in how ‘quality’ is defined. Almost all listed companies can in some sense be called competitive in what they do, and most manage to profitably sell products that customers want.

Intuitively, the ability to make a buck could be a marker of quality in and of itself. Cash is cash, after all. But it is the nature of this profit-making that investors tend to focus on when they talk about ‘quality investing’. And though it is subjective, ‘quality’ tends to refer to growing and consistent cash flows, underpinned by strong, high margins and businesses with strong competitive positions.

Sometimes, these qualities are most evident when sectors are compared side by side.

Airline operators, for example, face stiff price competition for the seats they sell, yet have little control and oversight of their major source of operating costs, consumer sentiment, or long-lead capital spending. Generally, that makes them more susceptible to economic cycles than a sector like software development, where the upfront costs required to build a niche and sought-after product can pave the way for years of reliably sticky customer demand and operational gearing.

It should be said that not all airline or software companies are created equal. What makes a ‘quality’ company often depends on whether products in its market are commoditised, and its level of specialisation within that market. Though there are lots of chipmakers around the world, Taiwan Semiconductor Manufacturing Company (TW:2330) is widely acknowledged to be the most advanced. Though thousands of its competitors try, only one beverage company has the mix of brand and distribution power of Coca-Cola (US:KO).

Together, consistency and high margins are a recipe for the kind of cash generation that allows companies to both reward shareholders and grow. For this reason, ‘quality’ stocks tend to come with higher valuations, reflecting expectations that they will outperform lower-quality stocks over time. Of course, that means using smart due diligence tools and valuation criteria to identify them.

That’s easier said than done in the best of times. But in the past year, as investors’ risk aversion has steadily climbed, hallmarks of quality such as growing free cash flow and strong and stable margins haven’t stopped share price slumps in otherwise excellent companies.

For proof look no further than our High-Quality Large Caps screen, one of the most successful automated strategies we have run in these pages over the past decade. Between 29 December and 16 June, the screen suffered a 28 per cent drawdown on a total return basis – a slightly worse decline than the screen’s peak-to-trough fall in the first half of 2020.

Were it not for the takeover-assisted 25 per cent total return from last year’s best-performing pick, cyber security outfit Avast (AVST), the screen would have likely underperformed the FTSE All-Share by more than 13 percentage points. But in most cases, share price declines weren’t mirrored by a collapse in margins. Indeed, operating margins across the 11 selections from 2021’s screen actually improved by an average of 2.6 percentage points, while sales expanded by a fifth compared to some admittedly Covid-dented figures from 2020/21.  

In the circumstances, the past year’s decline is arguably better than it might have been – even if it is the first time the screen has posted a negative annual return in its history. Certainly, investors will have factored in higher discount rates to their future cash flow forecasts, as well as a degree of demand destruction in the coming years.

But the stuttering rally in quality stocks since June’s lows – more than triple the rise in the benchmark over the same period – suggests there are buyers prepared to swallow short-term uncertainty for the chance to acquire good companies at a beaten-up price.

Whether or not those prices could take a further beating remains to be seen, but our High-Quality Large Cap screen’s track record shows why long-term investors might feel bullish. Since we started running the screen in 2011, it has returned 450 per cent on a total return basis, compared to 126 per cent from the FTSE All-Share. Even taking into account the past year’s fall, that translates to a compound annual growth rate of 17 per cent, more than double the 7.5 per cent from the benchmark and on a par with the best-performing funds over the same period.

The stock screens in these pages are intended as a prompt for further research rather than off-the-shelf portfolios, but if we factor in a 1.25 per cent annual charge to account for the real-life costs of trading, the screen’s overall return would decline to a still respectable 380 per cent over 11 years.

Methodology

Our large-cap version of the high-quality screen is interested in many of the same qualities of its smaller counterpart, which we last ran last month. These include positive free cash flow, forecast earnings growth, a history of margin expansion, improving returns on equity and manageable interest payments.

Where it differs is in its approach to value criteria. Rather than look to balance quality with relative cheapness, the large cap screen now takes a much more ambivalent view of a stock’s valuation, and instead focuses on companies with best-in-class returns on equity and margins.

Last year, these criteria were both diluted to get around some of the problems created by the big hit many companies took the pandemic and to cast the net wider over the FTSE All-Share, from where the results are drawn. This year, I have reverted to the old tests for top-quartile returns on equity and operating margins, but only require that companies show relative (rather than consecutive) growth on each of these measures over three years. The tests are as follows:

■ Return on equity (RoE) in the top quarter of all stocks screened in each of the past three years.

■ Operating margin in the top quarter of all stocks screened in each of the past three years.

■ Earnings growth forecast for each of the next two years.

■ Interest cover of five times or more.

■ Positive free cash flow.

■ Market cap over £1bn.

■ RoE growth over the past three years.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

This year, seven stocks passed all tests. Because our quality tests are share price agnostic, it stands to reason that five of them were also on the 2021 list – despite the less than quality market performance from last year’s picks. Indeed, three of this year’s companies – Relx (REL), Moneysupermarket.com (MONY) and Experian (EXPN) – passed all the criteria set in 2020, too, while Relx also made the cut in 2019.

There is something reassuring about this feature of the screen, given the investment case for quality stocks is best made as part of a buy-and-hold strategy. Indeed, the Geico screen we introduced last week – which looks for international stocks with long-term track records of consistently strong returns on equity – has a similar philosophy. Guinness’ Global Equity Income fund, on whose methodology that screen is loosely based on, likes to hold stocks for a minimum of three years.

This is only fitting, considering strong economic moats and returns on capital are not always reflected in short-term share price performance. Over time, however, such advantages tend to reveal themselves and reward investors in the process.