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One man's meat is another man's poison. The definition of quality varies from investor to investor. You could argue that quality mattered to Benjamin Graham, even though his stocks were called cigar butts. Benjamin Graham required that a company he invested in was profitable in every single year for the past 10 years, paid out dividends for at least 20 consecutive years and grew earnings per share by 33% over a decade. This is not a set of criteria that is easy to meet.
The characteristics I look for in quality stocks are as follows:
Pricing Power
Companies with pricing power have the ability to increase the price of their goods and/or services without chasing away customers or reducing the volume of goods sold. Customers of companies with pricing power typically emphasize more on the quality of the product rather than price, and they spend only a small percentage of their budget on the business’ product or service.
Recurring Revenue
Companies with recurring revenue as a large proportion of total revenue are regarded as having higher quality of earnings. Companies with subscription-based businesses and service-based businesses belong to this category.
Market Leadership
Market leadership is either a result of the network effect where the strong gets stronger or the blue ocean effect where a niche is only profitably served by one or a few market leaders.
Cost Efficiency
Low cost is one of two components contributing to high profit margins, the other being high price. Some companies are able to maintain a low cost base, by virtue of their size of operations i.e. economies of scale; others may be integrated upstream and have access to low cost raw materials or supplies.
Capital Efficiency
A capital efficient company uses the least capital to earn the most amount of income. Capital includes working capital such as receivables, inventories and fixed assets such as property, plant and equipment. A quality company that gets high scores on capital efficiency collects receivables from customers faster, holds inventories on a just-in-time basis, pays suppliers slower and reduces maintenance capex, which does not contribute to growth.
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