The Quality at Reasonable Price Way of Investing

Quality at Reasonable Price essentially mean buying good quality companies at a Fair Price. In essence, we are applying the mantra of how we buy to investing. However, to do this effectively we must be able to identify good quality stocks and their reasonable price.

What is quality? – Warren Buffet stated “There are only two sources of value in a company- Its Earnings and its Assets.” And to assess the quality of a company, we must find out the quality of its earnings and assets.

One of the most important metric to assess a company’s quality is to look at it RoCE- Return on Capital Employed. RoCE essentially means how much the company is earning on the funds it has deployed in its business. Now, the funds come from both the stakeholders – the shareholder’s funds as well as funds from its creditors. This is a measure of its efficiency in using capital. Naturally, we should compare this number with the company’s cost of capital. WACC, which stands for Weighted Average Cost of Capital, is essentially the cost of both its equity and debt in their proportion of its capital structure. A company having its RoCE in excess of its WACC year after year for long enough is a consistently good performer and hence good quality.

Apart from RoCE, what also matters is how the company is deploying its profits. As shareholders, we want companies to redeploy the profits into the business for further growth and any excess returns to be given to the shareholder in the form of dividend. What happens in many cases is that the company is having healthy profits, but is deploying its profits into new businesses which are unlikely to have the same profitability as its existing line of business. To assess this, we must look at the Free Cash Flow (FCF) after capital investments. A company having both good RoCE and FCF consistently over say 10 years is a very good quality company. This is the criteria used by MOneyWorks4me to mark a stock as Green.

After we have assessed a company’s quality, what we need to decide is about a reasonable price around which we can invest in it. This is called ‘anchoring’ and is used by all of us whenever we need to make an assessment of the price, we should be okay to pay. This is an important metric to look for, because even if the company is a good quality stock, if we buy it at a steep valuation, it is likely to underperform the market, given that in the long run the market value of the company is most likely to converge to its fair value.

Anchoring cannot be eliminated in investing and that makes using a good anchor very important. Past price is not a good anchor, nor is 52-week high and low as these are purely driven by the price the market is willing to pay at different times. We will be at a loss to make any sense out of this number. 

The are essentially two ways at arriving at an anchor. Let’s understand this from an example.

When we are looking to buy an apartment, we first look at apartments of similar specifications in the area, to come at a price which we think we could pay per sft. This is what is called a Valuation Metric in investing. When we apply a similar concept to valuing a company, what we see are different valuation metrics like Price to Earnings, PE, Price to Book Value, Price to Sales etc. Then we compare it with the industry, its peers as well as to its own history, usually as a median. A company having its valuation exceeding than what the median is taken to be expensive. This method of valuing a company is called relative valuation. MoneyWorks4me Alpha uses this method.