One term that frequently pops up in an investment manager’s lexicon is "quality"—but the definition of quality can vary considerably among different investors.
What Is Quality?
For conservative investors, quality implies financial robustness and consistent earnings, which act as a cushion against economic downturns. Alternatively, long-term growth investors interpret quality as companies with high returns on capital and enduring competitive advantages that fuel growth across multiple business cycles.
Our wealth management firm defines quality as companies that wisely allocate capital, build a resilient competitive position and maintain financial strength through business cycles.
No matter the investment style, a quality-focused investment manager must precisely define and communicate what quality means to them. SMID cap companies often get less attention from analysts and the media, requiring investors to undertake even more independent research.
A Look At The Comprehensive Quality Framework
The following comprehensive quality framework—encompassing evaluations of the management team, competitive position, balance sheet and earnings quality—enables investors to identify right-fit SMID companies and build portfolios that intend to reduce volatility in turbulent markets while delivering superior long-term returns.
Strong management team. We seek companies led by seasoned management teams with a demonstrated vision, prudent capital allocation and a focus on long-term profitability over short-term growth. These traits often correlate with a proven track record of creating shareholder value. Within SMID cap companies, strong management might come from company founders with deep business knowledge or leaders trained at larger, established companies.
A leading competitive position. Quality companies successfully carve out a leadership position or a proprietary niche in their markets, leading to stable or improving market share over time. These companies have competitive advantages that extend over multiple business cycles, with cash flow returns consistently above the cost of capital. In the SMID cap space, this might include market share leaders consolidating fragmented industries or emerging companies delivering superior products or services compared to large-cap incumbents.
Resilient balance sheet. The balance sheet’s strength is critical, especially during economic turbulence. Financial markets tend to penalize companies with weak balance sheets during downturns. Conversely, companies with rock-solid balance sheets provide downside protection in difficult periods. Assessing balance sheet health involves analyzing financial leverage ratios, interest coverage and market signals, such as credit spreads and rating changes. Effective balance sheet management in the SMID cap space often involves prudent leverage to invest in growth through capital spending or acquisitions.
High-quality earnings. Quality companies typically experience stable earnings and are less sensitive to the economy. This stability often translates into lower earnings volatility, and therefore, more stable stock prices over time. We look for companies with steady earnings—those not distorted by revenue recognition problems, inflated inventory or excessive write-offs. High-quality companies are usually free cash flow positive, demonstrating their ability to balance business investment with shareholder benefits.
What This Means for Investors
Investors who focus on high-quality securities will help protect their portfolios from market unpredictability. This approach offers significant downside protection during the most challenging market periods and strong returns during normal periods. For long-term investors, this approach is a reliable path to compounding wealth through the inevitable ups and downs of market cycles.
Brian Kute, CFA, has been with Johnson Investment Counsel since 1994. He is the director of research and a senior portfolio manager within Johnson Asset Management and is also a shareholder of the firm. Johnson Investment Counsel cannot promise future results. Any expectations presented here should not be taken as any guarantee or other assurance as to future results. Our opinions are a reflection of our best judgment at the time this material was created, and we disclaim any obligation to update or alter forward-looking statements as a result of new information, future events or otherwise.