Brand vs Quality

November 21, 2014 | Dian Chaaban


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“…but they’ve been around for so long and at one point, everyone had an IBM computer – plus the stock has made me some good money over the years, so it must be a keeper…right?”

Is how my new client responded when I told him that we should sell IBM from his old portfolio and replace it with a higher quality alternative in the same space. Many investors assume their portfolios are filled with good quality companies because they may have been goodies once upon a time - but - as economic conditions change, some companies miss a beat or take a wrong turn. Balance sheets can deteriorate, revenue trends may no longer resemble what they once did or management teams turnover for the worst.

A common mistake we are all guilty of is confusing “quality” with a strong brand. If a company has successfully built a superior global brand over many years - and that brand is recognized positively by investors – then some investors may also assume the stock behind the brand is a quality stock. This isn’t always the case and the reason as to why research and due-diligence in selecting stocks is so important.

The recent hike in global equities after the mid-October heart-attack (official term: correction) has now provided us with an opportunity to upgrade the quality of our equity portfolios because as we enter the mature phase of the global corporate earnings cycle, earnings quality is likely going to be challenged, and many low-quality stocks may not be up to the task…high-quality stocks tend to do well when earnings momentum slows - and since price-to-earnings ratios are elevated in the US (the world’s largest equity market), lower-quality holdings could become vulnerable to underperformance.

So, then, what exactly is Quality? We define “quality” as companies with solid balance sheets, impressive cash flow, strong and predictable earnings growth, and resilient revenue growth prospects. Quality companies also tend to deliver high returns on capital and earn high credit ratings. They are led by effective management teams who excel in competing and building industry-leading products/services. Quite often, quality companies will pay you dividends and, even better, grow them consistently each year. Awesome.

Speaking of dividends, many clients have been asking lately about the opportunity of purchasing companies in the oil & gas sector, while the sector seems to be “on sale” but the sustainability of dividends at US$85.00/bbl in the oil patch has become a looming concern. Reminiscent of the quality chat we just had, we believe a company’s ability to maintain its dividend depends on a multitude of variables, which include: financial leverage, payout ratio, decline in production, hedge book, production growth, and near term capex commitments. That said, in the medium term, we expect oil prices to remain broadly in the $75–$100/bbl range but the key catalysts include current sanction talks with Iran ending November 24 and the next OPEC meeting on November 27more on that next week…