Why Quality Matters
The International Equity Team at Morgan Stanley Investment Management believes that the ability to generate high and consistent returns on operating capital, which in turn may produce strong free cash flow, is the signature of a high quality company and the foundation of sustainable compounding over the long term. Such high quality companies are rare, and we outline below some of their key characteristics.
Dominant Market Share, Powerful Intangible Assets
Dominant market share usually means a company is less likely to compete on price and instead compete on innovation, advertising, promotion and customer service, all of which are typically most effective on brands, licenses, patents, networks, distribution channels and after markets. These are good examples of intangible assets. As such, the Investment Team prefers to own companies with strong intangible assets since they tend to have a stronger competitive edge against new entrants. Commodity driven companies, which are driven by their physical assets, are avoided.
Pricing Power, High Gross Margins
Being able to stimulate sales and maintain prices, or improve prices without sacrificing profit margins is a key quality differentiator, the team believes. Innovation and branding initiatives require consistent and meaningful investment in research and development (R&D) and advertising and promotion (A&P). Evidence of pricing strength can be seen in gross margins; how high they are and how stable they are. Companies whose pricing is driven not by their own initiatives, but by market supply and demand are avoided, such as commodities.
High Returns on Operating Capital Employed
Return on operating capital employed (ROOCE) is a ratio comparing the operating profit generated by a company to the operating capital it has. A high and sustainable ROOCE, in the Team’s view, serves a good signal of the ability a company has to generate strong free cash flows. Companies with large physical assets, often referred to as capital intensive, typically generate lower ROOCE, converting less of their operating profit into free cash flow. Therefore, capital intensive businesses are avoided.
Strong Free Cash Flow (FCF)
Earnings are an accounting measure; you can’t spend earnings, only observe them. You can, however, spend FCF, and for this reason it is of greater significance to the team. Benefitting from R&D, A&P and customer service to motivate additional sales, capital light businesses with powerful intangible assets generally grow and generate FCF at the same time. They do not typically need to add capacity for extra revenue, which would consume FCF. Businesses which consume free cash flow as they grow typically struggle to compound and are avoided.
Company management is core to the team’s definition of quality; the team looks for evidence of good operational management, good leadership, strong governance and a shareholder-driven mind-set.