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Why Company Quality Matters to Investment Returns

2/5/2024

Is our reliance on key quality metrics the key to the success of our small-cap stock strategy?

Recent writings from Ben Inker, Tom Hancock, and Lucas White of asset manager GMO focused on research about the role that “quality” plays in the performance of stocks and bonds, and perhaps even more especially in the realm of small-cap stocks. Their conclusion is that high quality companies—defined as those with high profitability, low profit volatility, and minimal use of leverage—deliver higher annualized returns with lower volatility than low quality stocks.

The effects are impressively apparent (and somewhat contrary to popular wisdom) in small company stocks during both good and bad economic times. During recessions, these higher quality companies can take advantage of opportunities to expand and grow while weaker peers can be fighting for survival.

These findings align fairly closely with how the SmallCap Informer incorporates company quality assessments in the analysis of stocks covered in the newsletter.

To summarize the SmallCap Informer approach to small company selection, the following are the key considerations.

1)    Identify companies that are profitable with clear drivers of future growth. Consistent past growth is a bonus, though it can be harder to achieve for smaller and younger companies.

2)    Focus on quality companies with margins that compare well to peers or similar companies. Consistency and stability of margins is a bonus, and use of leverage must be prudent.

3)    Buy these stocks at reasonable values (compared to historical levels and/or when compared to expected growth).

4)    Once the above have criteria have been met and stock purchased, wait for the identified growth drivers to kick in and cause P/E ratios and share prices to appreciate.

I call this approach “Q-GARP,” an adaptation of the style of investing popularized by Peter Lynch in the 1980s and ’90s as legendary manager of the Fidelity Magellan mutual fund. Lynch employed a methodology called “Growth At a Reasonable Price” (“GARP”).

The added element, “Q” (for “Quality”), reflects our understanding of how higher-quality companies perform throughout the economic cycle, and how these companies often see their shares trading at lower levels of volatility.

While quality can be defined in many ways, we take a shortcut and focus on pre-tax profit margins, both the consistency of margin over time and in comparison to the margins of peers and competitors.

We review profit margins on a pre-tax basis to eliminate differences in the tax rate paid by companies of different sizes or in different stages of their life cycles. This is less of a concern after the 2017 corporate tax changes for domestic companies, but still allows for apples-to-apples comparisons when international-based companies are brought into the mix.

It is our contention that managers of companies with “better” pre-tax profit margins are doing a “better” job at managing all of the various expense inputs (labor, energy, materials, occupancy, administrative, etc.) and all of the revenue generation aspects of the business.

Our experience is that executives who successfully manage all the moving parts of the operations side of a business are also handling the company’s capital needs just as adeptly. Dividend payouts will be well-covered, interest coverage will be healthy, and debt leverage will be prudently utilized.

Of course, no rule of thumb is universal, and we occasionally find companies that meet our quality standards but carry concerning balance sheets. For these, it is straightforward enough to conduct further analysis as needed.

Our quality focus leads us to shun outright unprofitable businesses, turnaround opportunities, and companies with flatline or negative growth trends.

Our long-term track record of outperforming the S&P SmallCap 600 index is strong, and, backed up with how well the approach dovetails with the conclusions of the GMO team, there is ample evidence that this Q-GARP approach works for individual investors.

Incidentally, in practice over the past twelve years, we have learned that high growth, high P/E stocks often carry more risk (in terms of volatility most especially) that many investors can comfortably tolerate, which has pushed us further towards the small-cap value style quadrant and away from small-cap growth. But more on that in a future issue.
 

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Thanks to all subscribers who attended our 2024 Small-Cap Outlook Webinar in January. If you missed the live session, the replay is available here in the Subscribers area of www.SmallCapInformer.com.

Our subscriber-exclusive 2024 Top Stocks Special Report is also available on the website, calling out six stocks which may be poised for outsized returns in the coming year and beyond.


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The world is a-changing, and the current robust global travel industry has journeyed a far cry from where it crashed and burned during the pandemic. Our focus company in this issue of the SmallCap Informer is one potential beneficiary of these trends, and whose stock may soon be flying high once again.

On behalf of our entire team, we wish you the best for 2024. As always, stay the course!

  • DOUG GERLACH

Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 49 high-quality small company stocks currently covered in the newsletter.