Quest for quality

If you look in the dictionary, 'quality' is a simple word. The most common definition of quality is something like 'How good or bad something is' or 'A high standard or level'. It's one of those words whose meaning is so obvious that it can't be put into words. Everyone already knows what it means, and there is nothing that a dictionary definition adds to our understanding.

When it's clothes, food, phones, or any other everyday object, judging quality is not so difficult. But stock investments are a different matter. If you ask anyone, absolutely anyone, whether they invest in quality stocks, you will get a yes for an answer. You'll get some definitions for quality stocks, such as stocks that are available at a reasonable valuation with a long-term perspective. Everyone in the investing world says this or something like this. I mean, who would ever say the opposite?

And this makes the challenge of identifying quality stocks that much harder. Unlike tangible products, evaluating the quality of a stock is an exercise in trying to look into the future. Since you cannot directly look into the future, you follow the clues. Obviously, looking for these clues is a humongous task. At first sight, it would require, at a minimum, scrutinising a vast number of financial statements, understanding industry and sector dynamics for a large swathe of businesses, analysing past management decisions for the companies and so on. Then come external factors such as economic outlook, regulatory frameworks, global events, and so much else that could impact a company's business prospects, and finally, on top of all that, the markets themselves. Obviously, a point-in-time snapshot of all will not cut it at all. Many things are constantly changing, but some remain constant, making evaluating quality stocks a continuous process rather than a snapshot.

In the cover story of 'Wealth Insight' May 2023 issue, our team has assembled a methodology that implements a framework for evaluating quality in a large number of stocks and then arriving upon an inevitable list. This framework is based upon a strategic approach evolved by the well-known investment manager Bharat Shah. Our team used the book by Shah titled 'Of Long-Term Value & Wealth Creation from Equity Investing' as a guide. Shah's central tenet is founded on the belief that top-tier companies - assessed through ROCE and some additional criteria - present the most optimal opportunities for generating wealth in the long run. Our goal was to examine the outcomes of investing in high-calibre enterprises. The team's research investigation revealed a distinct and immediate connection between capital returns and stock price increases over 10 years.

Of course, I must point out our regular caveat that this is an objective exercise whose goal is education. It does not constitute a set of stock recommendations, as our Value Research Stock Advisor service does. On top of the numerical exercise, investors must add a layer of subjective evaluation. The significance of subjective judgement cannot be understated, as it develops through experience and a willingness to pose challenging questions. Evaluating stocks purportedly objectively without grasping the subjective and nuanced aspects of investment logic leaves investors in a situation where they lack any meaningful comprehension. Of course, nowadays, the opposite is also true. There's no shortage of hyped companies, regrettably including highly-touted unicorns, that showcase only the subjective part - just stories - that fail ever to find any concordance with their financial performance. The final call on quality must be based on numbers, human judgement, and stories.

Actually, that's not the final call. The final call is made by investors looking at their own financial goals and circumstances and judging the suitability of each investment in that light, but that's a discussion for another day.