Chapter 3: Screen For High-Quality Business Models

Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises

Aug 23, 2024

Welcome to Chapter 3 of the draft manuscript serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.

I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real time.

Chapter 3 evaluates how to measure a company’s senior management returns on growth, profitability, equity, and capital, essential metrics for quality-driven investors.

Chapter 3

Screen For High-Quality Business Models

Concentrating investment research on the business’s fundamentals increases the potential to pick the alpha-achieving stocks of enduring enterprises.

This chapter evaluates a business’s senior management returns on growth, profitability, equity, and capital and how each is essential for quality-driven investors.

We’ll uncover prime examples of publicly traded companies’ C-suite-driven metrics to analyze and measure the fundamentals of high-quality business models by focusing on senior management’s partnerships with the board of directors, shareholders, employees, customers, vendors, and the community that produces, delivers, and consumes the enterprise’s goods and services.

Because we avoid unreliable predictive analysis, quality-driven investors look for companies with actual revenue and earnings growth, profitable operations, and superior returns on equity and invested capital.

Consider including internal customers when researching companies, as happy employees lead to quality products, loyal customers, and sustainable profit margins.

Evaluating Management Effectiveness

Measuring the performance of senior management is paramount to owning slices of excellent companies.

At a minimum, evaluate a business’s returns on management by analyzing and measuring revenue and earnings growth, profit margins, and returns on equity and invested capital. Remember to limit the due diligence of a company’s fundamentals to current wealth instead of unreliable predictive analysis or business modeling overkill.

When considering the worthiness of its stock’s inclusion in a portfolio, examine the company’s actual growth metrics as opposed to speculative forecasts of what might occur with future revenues, earnings per share, free cash flow, or dividend growth. Seek cash-generating companies providing wide, or at least comfortable, safety margins. Favor businesses with efficient and transparent management that leverage compounding returns for stakeholders.

One challenge of evaluating the business model and the executives who manage it is the propensity to discover inadequacies or even questionable behavior. However, by conducting audits of businesses whose shares we own or products and services we buy to eliminate what misaligns with our beliefs and values, we’ll manage a light portfolio as investors or a bare-bones lifestyle as consumers. Hence, focusing on the management-driven fundamentals of chosen businesses best serves quality-driven investors.

Companies with robust fundamentals producing quality, in-demand products or services are the foundations of alpha-achieving stock picking. However, we are investing in an organization’s human resources as much as the assets and liabilities listed on the balance sheet, margins on the income statement, and free cash on the cash flow statement. Nevertheless, quality legacy companies endure, regardless of the leadership at any given time.

Real Growth in Revenue and Earnings

Remember to seek companies that are already growing, regardless of any promises for growth. Evaluate minimum three-year trailing revenue increases or the compounded annual net sales growth rate.

Revenue growth is the compounded annual sales growth rate over the specified period. When analyzing a business, stay biased toward established growth instead of speculative executive guidance and sell-side analyst projections.

In addition to revenue growth, minimum three-year earnings per share growth is a critical indicator of the company’s fundamental strength and commitment to increasing the wealth shared with owners. Whether measuring revenue or earnings growth, sift for double-digit—or at least favorable compared to the industry—compounded annualized growth rates or CAGR.

Top and bottom-line actual growth rates are the primary measures of an enterprise’s current and potential endurance.

Operating and Net Profit Margins

Is the company profitable?

Only speculators and misinformed investors go long stocks of companies losing money. A no-brainer rule of quality-driven investing is that if we don’t want to lose money, avoid taking long positions in unprofitable businesses. Instead, look at the trailing twelve-month operating margin—EBIT or earnings before interest and taxes, divided by revenue—and net profit margin, or the trailing twelve months of income after taxes divided by sales.

The net profit margin is the percent of revenues remaining after paying operating expenses, interest, and income taxes for the trailing twelve months or TTM, divided by trailing sales, also called NOPAT, or net operating profit after taxes. Remember to screen for profitable companies to bypass unnecessary speculation.

Quality-driven investors favor double-digit top- and bottom-line margins or at least superior growth for companies within industries where single-digit margins are the norm. Look for competitive profit margins, providing cushions against downward macro- and micro-economic cycles.

Return on Equity

The return on equity, or ROE, reveals how well the company generates net income as a percentage of the total shareholder investment in the stock and is another reliable measure of management effectiveness.

Return on equity is trailing income available to common shareholders divided by average stockholders’ equity from the most recent fiscal year or MRFY and the year-earlier fiscal period, expressed as a percentage.

Target an ROE of 15 percent or higher to discover shareholder-friendly management. Keep in mind that board-authorized share repurchase programs typically accelerate ROE. In other words, be aware of senior management using aggressive stock buybacks at premium share prices to inflate the return on equity. On the contrary, if executed by the board of directors with sound strategy and at sensible prices, stock repurchases provide a value-add to shareholders of record.

Remember, company managers often commit the same malpractice as professional and retail investors by overpaying for shares when executing mergers and acquisitions or buying back stock.

Return on Invested Capital

Quality-driven investors look beyond earnings per share or EPS and measure the return on invested capital or ROIC to see how much a company earns on the capital it deploys from operations.

Return on invested capital is net income after taxes divided by the average of total equity plus the sum of total long-term debt, total other liabilities, deferred income taxes, and minority interest, expressed as a percentage.

ROIC measures how well a company uses its capital resources to generate excess returns or how senior management allocates its financial resources to create incremental profits. Target a return on invested capital of 12% and higher.

The weighted average cost of capital, or WACC, illustrates the corporation’s cost of capital, weighing each category in proportion. WACC calculations consider each category of financial resources or sources of capital, including common stock, preferred stock, bonds, and any other long-term debt.

Remember, the return on invested capital is only as reliable as the underlying weighted average cost of the capital. Thus, investors must confirm that the ROIC exceeds the WACC by a comfortable margin to demonstrate management’s ability to outperform its capital costs.

Return on invested capital, including its weighted average cost of capital, presents a primary measure of the enterprise’s potential to compound annual returns on the stock price over long periods. However, when the ROIC diminishes toward the underlying WACC, the business faces the inverse threat of a decrease in valuation and an increase in risk.

Quality-driven investors consider ROIC an essential indicator of a company’s current wealth and potential for enduring shareholder value.

Remember the Internal Customer

A unique approach of quality-driven investors is to analyze the impact of internal customers by measuring employee satisfaction, including the rank-and-file evaluation of the chief executive officer or CEO.

Although gathered from nonscientific data from the all-too-biased internet, a snapshot look at employee morale quantifies the cultural dynamic of the organization. Job search sites like Glassdoor and Indeed are ideal for evaluating employee reviews, including CEO ratings. Employee reviews and rankings of the company and CEO are often intertwined. Everything starts with leadership. Respect for the CEO, as shown by those working within the same culture, has the propensity to move the needle.

Satisfied employees deliver quality products and excellent services, translating to loyal customers and sustainable profits. A dominant market share held by a significant player within an industry attracts faithful customers regardless of employee morale or CEO popularity. Nevertheless, poor-performing CEOs produce value opportunities. Thus, buy and hold the common shares of wonderful companies trading at sensible prices, no matter the chief at the time of purchase.

Remember to seek high-quality companies with attractive long-term prospects. The potential for compounding total return on invested capital and dividends paid increases when the stock exhibits a wide margin of safety at purchase. The enduring quality of the operator remains paramount to the success of the investment over time.

The proverbial chicken and egg question begs, “What comes first, a quality company or competent management?”

Senior executives and board members come and go. Therefore, it is imperative to own slices of companies that demonstrate enduring quality operations with an outstanding overall return on management despite the inevitable turnover. And when the occasional and unintentional misfire hire is the newest member of the C-suite, resist pressing the panic button. Instead, sit back and watch as the market sends in the prowling bears. Next, take advantage of the sudden out-of-favor enterprise to buy more shares of a high-quality business at temporary bargain prices.

Invest in the Executive’s EQ

Consider an investment of time in observing the executive’s emotional intelligence.

Emotional intelligence is an individual’s capability to be acutely aware of the sentiments and motivations of self and those of others, discerning between the different feelings and addressing each as appropriate. Numerous studies and books have argued that so-called emotional intelligence, or EQ, outperforms the more understood intelligence quotient, or IQ. Productive individuals use sensory information to guide thinking and behavior and manage or adjust emotions to adapt to environments or achieve goals.

The same holds for corporate management. Like the Wall Street institutions that cover them, high IQs supported by MBAs from prominent universities are often a prerequisite for entry to the C-suite of corporate America. Regardless of their IQ or alma mater, EQ is the driving force behind successful managers. The emotional intelligence of the executives can predispose them to produce ethical and profitable outcomes.

As a former executive, I observed leaders with high EQs and the resulting superior leadership abilities of humbled but driven. They seemed to outperform peers who relied more on high IQs, unique talents, or charisma. For example, an adage in professional baseball is that star players rarely become winning coaches.

Nevertheless, managers with inherited high IQs and developed high EQs possess rare gifts to achieve legendary status. Think Warren Buffett at Berkshire Hathaway, Tim Cook of Apple, and Satya Nadella at Microsoft.

Companies with High-Quality Business Models

At the time of this chapter’s writing, our family’s basket of stocks, as represented by the QVI Real-Time Stocks Picks Concentrated Portfolio, held select companies that consistently exhibited exceptional returns on management, thus demonstrating the significance of solid leadership.

Sector | Industry | Company | (Ticker Symbol)
Communications services: media and internet services provider Alphabet, Inc. GOOGL 0.00%↑
Consumer discretionary: apparel retailer TJX Companies, Inc. TJX 0.00%↑
Consumer staples: soft drink beverages producer The Coca-Cola Co. KO 0.00%↑
Financials: multi-sector holding company Berkshire Hathaway, Inc. $BRK.B
Health care: drug and medical supplies distributor McKesson Corp. MCK 0.00%↑
Industrials: freight railroader Union Pacific Corp. UNP 0.00%↑
Information technology: hardware and services provider Apple, Inc. AAPL 0.00%↑
Information technology: systems software producer Microsoft Corp. MSFT 0.00%↑

Each representative company consistently performed with positive revenue and earnings growth, profit margins, and returns on equity and invested capital.

Quality-driven investors increase the likelihood of market-beating returns by focusing on the fundamentals that matter without regard to the institutional pressures of fast-money-seeking clients and quarterly out-of-the-park financial performance. The cumulative total return outperformance against the benchmark by these select companies in our family portfolio reminds us that beating the market is possible over a long-term holding period when investing in companies with high-quality business models generating substantial current wealth.

The preceding examples omit the listed companies’ other current wealth and present value checklist investing strategies, such as the value proposition, shareholder yields, valuation multiples, and enterprise and share price downside risks discussed in other chapters. Therefore, readers should conduct further due diligence as screening management performance is part of the overall proprietary checklist analysis of quality-driven value investing.

Numbers Don’t Lie—But Humans Do

Remember that numbers don’t lie, which is a cliche, whereas the human propensity to finagle is a fact of life.

When a company misses or beats the Wall Street sell-side analysts’ earnings estimates, the question arises, “Who are the actual winners and losers, the management or the analysts?”

Contrary to the proverbial Wall Street quarterly win, lose, or draw competition, it becomes more believable if senior management misses or beats its guidance despite any inherent ability to manipulate the forecast. Nevertheless, a reminder of the all-too-often earnings headline that reads:

“XYZ Inc.. beats earnings estimates by $.01.”

The one penny wins remind investors that numbers are incapable of lying, although the individuals driving and crunching them forever hold the capacity to re-engineer them. Moreover, senior executives of varying qualities will surely come and go when least expected. Therefore, stick with companies with durable value propositions and high-quality business models, regardless of who’s in charge.

Measuring actual returns on management compels quality-driven investors to limit precious capital to the stocks of enduring operators held for the long term to profit from the compounding returns courtesy of superior capital allocators.

About the Author

David J. Waldron is the contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, TalkMarkets, ValueWalk, MSN Money, Yahoo Finance, QAV (Australia’s #1 Value Investing Podcast), Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.