Key Questions: How Does Key Wealth Define Quality Within Our Internally Managed Equity Strategies?

Recently, as broad equity indexes have climbed higher and set new all-time highs on nearly a daily basis, a subset of stocks has attracted considerable attention as they have soared strictly on the basis of speculation, as opposed to fundamental or economic reasons. These are not the types of stocks we like to engage with in our internal strategies. Instead, our investment process is centered around quality companies. In this article, we offer additional details about our process and provide greater insights into our definition of “quality.”

When referring to quality, there is no single agreed-upon definition. However, in general, quality companies are growing, have solid balance sheets, provide a sustainable value proposition, and are led by proven management teams who are successful allocators of capital. While some of these measures are qualitative, many are also quantitative. By aggregating and setting criteria for several of these quantitative metrics, we believe we can better define, and determine, quality companies. Through the construction of a proprietary quality tool, our process seeks to identify companies that display top-tier quality characteristics. This deeper understanding of quality allows us to better position our internally managed strategies to deliver on the quality mandate that has historically been additive to our investment performance.

Key Wealth’s equity team defines quality companies as firms that possess a strong track record of growth, exhibiting positive company-specific characteristics including revenue, operating income, and earnings quality. Furthermore, a strong return is also considered and is measured through the return on invested capital (ROIC). Finally, leverage is evaluated through metrics such as debt-to-free cash flow (FCF), debt-to-equity, and interest coverage. This definition results in seven metrics that we use to determine the components of a quality company.

Below, we have listed, in detail, our seven attributes of quality companies and briefly explain why we view each as an indicator of quality:

1. Annual Revenue Growth

This measure displays the percentage increase, or decrease, in revenue by comparing the current period with same period in the prior year. We view steady, predictable growth as a strong sign of quality. This growth could be in the form of gaining market share or potentially from entering new markets. It remains important for an analyst to comprehend the underlying reason behind the growth trend and evaluate whether the growth is maintainable.

2. Operating Income Growth

A metric that measures, in percentage terms, the relation of earnings before interest and taxes to revenue to get a clearer picture of efficiency. The initial profit for a company, after all the sales and costs of goods have been calculated, only tells an investor half the story and only through the lens of the profitability of the product or service itself. Quality investors are interested in the full story and want to consider the operations as well. Strong, quality companies are also good operators.

3. Earnings Quality Growth

This is a calculation of the free cash flow (FCF) to net income. A higher amount of free cash flow, within profits, can be thought of as higher-quality profits. More free cash allows companies the flexibility to invest, grow, or return capital to shareholders as seen as necessary by the respective management teams. Each company may have different goals for the free cash flow, but higher quality profit provides valuable optionality.

4. Return on Invested Capital (ROIC)

ROIC is a return measure that calculates the net operating profit after taxes (NOPAT) to invested capital. Return on invested capital indicates how effectively a company is using the sources of capital (equity and debt) invested in operations. If a company is investing funding and generating higher returns with this funding relative to peers, this is a sign of quality. Prioritizing companies with a higher return on invest capital ratios can be a powerful distinguisher and one that we prioritize in our process.

5. Debt-to-Free Cash Flow (FCF) Ratio

Simply put, this measures debt to free cash flow (FCF). This metric assists us in determining the manageability of the current debt load. A more manageable debt load is an indicator of a higher-quality company. This allows the company flexibility to use free cash flow on dividends, share buybacks, or acquisitions rather than to just pay back debt.

6. Debt-to-Equity Ratio

Another straightforward metric, this ratio calculates the debt to equity. This measures the amount of debt a company has on the balance sheet relative to the amount of equity. Again, we are trying to identify companies with more manageable debt loads. We believe that a strong balance sheet is a key to a quality company.

7. Interest Coverage Ratio

Finally, our last metric is a measure that calculates earnings before interest and taxes plus interest-to-interest expense. This ratio explains how efficiently a company manages interest obligations. This can be helpful in displaying how well a company can still meet obligations if profit were to decline during weak environments. A quality company should have a higher cushion to ride out unexpected storms.

Our process employs a proprietary tool to score companies via these seven quantitative quality metrics. Every company is graded on a pass/fail basis for each metric, per the criterion we have set internally. Basically, the higher the number of metrics passed, the higher the quality score. We also consider a sliding scale when defining quality, as this allows flexibility within the tool for companies that may be relatively strong in quality but may just be weaker in one or two metrics at a particular time. An analyst reviewing a company may also need to use his/her best judgement to determine whether the failing metrics are a legitimate concern, depending on independent research and potential adjustments. Basically, we do not want to eliminate a quality company from consideration based on one or two metrics if they are not long-term concerns.

Quality is typically in the eye of the beholder, but with our process, we’ve attempted to minimize subjectivity and inject rigor by defining quality using specific, time-tested metrics. In our view, having a process-driven approach gives us the ability to confidently express quality within our internally managed equity strategies. Instead of communicating quality in a subjective manner, we can now objectively communicate quality through the application of this defining process. We believe this approach ensures the highest quality standards are met for the benefit of our clients and the portfolios they have entrusted us to manage.

For more information, please contact your advisor.