The joy of investing in quality companies is not only that they tend to outperform, but that they do so in such an enjoyable way because of their habit of holding up well during bear markets.
This week, Citywire Elite Companies searches for quality plays among the favorite companies of the world’s top portfolio managers. This is a new screen in our regular list of data dives.
For readers who want to skip all the why and how and get straight to the stocks, scroll down to the bottom of this article for a list of 22 elite, top-rated companies.
Read our recent profiles of two of the world’s highest quality investors.
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Elite + quality
Citywire’s innovative elite company rankings are a quality screen in themselves.
For companies to have a top rating, they usually need compelling support from several of the world’s best portfolio managers. This means their tires must have taken a thorough beating.
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However, the managers tracked by the elite firms (about 3% of the 10,000 equity managers worldwide) use a variety of investment strategies, from value to momentum and more. That’s why we present screens that focus exclusively on quality.
A key attribute of quality companies is consistency. This means that screens designed to determine quality must return many of the same names every time.
With this in mind, Elite Companies is putting together several screens of varying quality, each of which will appear approximately every six months as part of our regular series of weekly data dives.
Dive into data about elite companies
Each week we run one of six (previously five) simple but powerful Citywire Elite top-rated stock screens to uncover investment ideas for readers. Each week we look at one of six screens. They are:
Mix recipe
The ability of high-quality companies to create shareholder value—or “integrated” value—is determined by two ingredients.
- The first is the company’s ability to earn high returns on the investments made in its business. For high-quality companies, these returns should be significantly higher than what shareholders would expect to receive in the market if the company were returning cash rather than reinvesting it.
- The second factor that determines a quality company’s ability to create value is its ability to reinvest money—its growth potential.
Criteria
This week’s focus is on the first of two pillars: ROI.
The measure of profitability used in our analysis is return on invested capital (ROIC). This ratio attempts to show how efficiently a business generates profits at the operating level before financing options (such as the use of debt) come into play.
The screen also shows companies’ earnings before interest and taxes (Ebit) as a percentage of sales.
Ebit margin is a great indicator of quality because a high margin often means that a company has a product or service that its customers are willing to pay for because they consider it special and unique.
A high Ebit margin also suggests that a company’s competitive advantage is not being overwhelmed by high operating costs, as may be the case with young, growing companies, for example. The screen is also looking for improvements in these quality metrics over the years.
Other tests used on the screen focus on decent earnings-to-cash conversion, limited financing costs, and earnings growth forecast.
Mechanics:
We start by selecting the top 20% of large- and small-cap companies (market value under $2.3 billion) among the elite investors we track. All companies must have a rating of at least AA.
We then select those that tick the following boxes:
- ROIC ranked in the top third of all companies reviewed for each of the last three years and was higher at the end of the period than at the beginning.
- Ebit margins are in the top third of all companies reviewed in each of the last three years and are higher at the end of the period than at the beginning.
- Forecast earnings per share (EPS) growth for each of the next two 12-month periods and EPS growth for the last three months.
- Interest coverage (Ebit to financing costs) is more than five times.
- Cash conversion greater than 80% is based on either free cash flow to earnings after taxes or operating cash to earnings before interest, taxes, depreciation and amortization (Ebitda).
results
Some companies featured on the screen are of higher quality than others. For example, AAA rating. Nvidia (US: NVDA) looks like a quality compound on steroids, although there are questions about how long the current surge in AI spending, which is driving staggering growth, can continue.
Compare this to the AAA rating PlutGroup (US:PHM), which has clearly fallen on hard times (see chart below).
It’s not surprising that Plute has experienced losses at some points in its history, given that it is a homebuilder and homebuilding is a highly cyclical industry. However, this is a quality business in this industry.
According to one of Elite’s 13 backers, Jay Kaplan, manager of the Royce Small Cap Value Fund, “This is a leading company in its industry, with a management team that has an excellent track record of efficient capital allocation and a shareholder focus.” returns.
In the coming weeks, we’ll take a closer look at some of the companies highlighted by this quality check. For now, here are the results, ranked by their popularity among the top investors whose holdings Citywire Elite Companies track.
Source: FactSet. EPS = earnings per share. PEG = price to earnings growth. Forecasts for the next 12 months.