Efficiently Inefficient #9 : The notion of Quality in Discretionary Equity Investing

As a follow to our previous article, we will delve deeper into discretionary equity investing. Remember that discretionary equity investing can be challenging task as the field is highly competitive and there are a lot of brains chasing the same few investments in the market.

It largely boils down to what investors perceive as the quality of a company:

a) Growth

It's easy to just reduce growth to one metric like compound annual growth rate of revenue, but I can hardly see it work when I back-test portfolios which use this criteria. Good sustainable growth can result in bigger free cash flows, imagine a store that found a way to increase sales without increasing their operational expenses. Growth can also be bad if it comes from manipulating accounting figures. imagine a company growing by acquiring rivals at high prices.

Somehow a growth investor needs to take all these considerations into account.

b) Profitability and Earnings Quality

The other factor to take into account is the profitability of the business. A profitable company of hihg quality has a great profit margin and has a history of high free cash flows.

But lower quality companies can game this by moving expenses into the future to inflate current figures.

c) Safety

A third element of quality if safety. Safe companies are predictable and this can come in the form of a lower beta. Some investors need to delve into the past variation of profitability by examining how the stock has performed in the Great Financial Crisis.

d) Payout and Management Quality

The final element, which is the element which I simply cannot handle is how friendly the company is to shareholders. The best discretionary investors have access to upper management and can tell whether they are managing the company for themselves or shareholders. As I do not have access to management, I have to use a proxy measurement- companies that return money to shareholders generally care about shareholders. With less cash in their hoard, the managers also would need to be more disciplined when they run the company.

At this stage, I'm trying link up the concept of quality to a discretionary investor to this other book I am reading written by Aswath Damodaran called Narrative and Numbers : The Value of Stories in Business. Perhaps in crafting a narrative for yourself if you are a growth investor, you would need to convince yourself that your investment is of high quality based on these four dimensions. After which you can proceed to assess the plausibility of your story by linking it up to accounting figures.

Whatever it is, this would be quite a difficult intellectual exercise if you are a retail investor. More likely, you will fall in love with a stock before can craft a compelling narrative based on it.