"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." - Warren Buffett
This research is focused on the fifty highest-quality companies trading on U.S. exchanges according to the following characteristics:
- a five-year average return on equity of over 20% (15 year for cyclical companies) using free cash flow rather than reported earnings
- low or no debt, and, if debt, companies that cover interest at least five times by free cash flow
- low capital expenditure requirements in relation to free cash flow (two years earnings plus depreciation, minus five year average capital expensitures) and that have capital expenditure growth much lower than free cash flow growth, an important indicator of quality of competitive advantage.
Those criteria generate about 200 companies. From those, I identify fifty with the highest return on capital and strongest balance sheets, the focus of this research. As I write this in late April 2017, a major effort is underway to create on this website an information hub on which professional investors can exchange information and perspectives on those fifty companies. That will be complete by the end of June 2017.
After research, I select ten that offer the best value (in relation to the two hundred quality companies in the database) relative to free cash flow. Those ten are the basis of my own investments and of the model portfolio for this publication.
Finally, in addition to a careful review of these companies' financial statements and published materials (analyst reports, 10Ks, 10Qs, 8Ks, Proxy statements, analyst research, articles in the business press, earnings calls and transcripts), aA major element in this research is interviews of those with informed perspectives on a company and its competitive position: management, major shareholders, directors, former directors, competitors, customers and suppliers.
See the Methodology section on this website for more on my use of free cash flow versus reported earnings, which is a principle element in this research.
Quality And Value
Numerous studies have shown that over the long term, the highest compounded rates of return are generated by long term investments in companies that combine high profitability, low debt and that offer reasonable value. One particularly comprehensive study by Robert Novy-Marx, professor of Business Administration at the Simon Graduate School of Business at the University of Rochester, New York, compared the results of a variety of quality and value criteria, and concluded that the optimum approach combined both:
Value strategies endeavor to acquire productive capacity cheaply. Traditional value strategies do this by buying assets at bargain prices; quality strategies do this by buying uncommonly productive assets. Strategies based on either of value’s dimensions generate significant abnormal returns, but the real benefits of value investing accrue to investors that pay attention to both price and quality.
You can read the article here, or click on the table above. The article is worthwhile.
Northern Trust's Quality Company Scoring System
Taking Novy-Marx's research a step further, Northern Trust developed a set of quality company characteristics that it has been employing successfully for some time. Their criteria:
The following two graphs of the performance of the companies that met these criteria, one of the S&P 500 and the other of the Russell 3000, show the soundness of this approach.
You can read the entire report here.
I developed computer software that allows me to apply criteria almost identical to those employed by Northern Trust Quality. Each quarter I scan the financial statements of hundreds of companies identifying emerging trends. The software also applies five different approaches to estimating intrinsic value based on a company's trailing twelve month earnings, dividends and free cash flow, and compares the result to both the company's historic price-to-value characteristics, and to the two hundred other highly-profitable, low-debt companies in my database.
In this way I'm able to come to a conclusion on a reasonable premium for the highest-quality companies in America. For more on this, see the Methodology section on this website, as well as my blog post: Value Versus Quality In Investing And In Life. In particular, please see the quote from John Huber, Saber Capital Management, offering his thoughts on Fastenal.
I publish at least weekly on the results of new research and new developments affecting my Top Ten companies. Reports contain:
- Detailed fundamental statement analysis
- An estimate of intrinsic value
- A management and board of directors assessment based on record of accomplishment, insider ownership, recent insider transactions and shareholder-sensitive CEO compensation relative to peers.
- Quality of franchise based on returns on equity and capital, and operating income growth in relation to debt and capital expenditure growth. Only the highest-quality companies can grow without increased debt and capital expenditure.
When a company is dropped from the Top Ten, and replaced, the reason for both is outlined.