Quality stocks, why bother?

Institutional investors and grey-haired market commentators often refer to it; Quality. 

But what is it exactly and does it really matter in a low volume share market that hasn't made any sustainable progress in 2.5 years?

The simplest definition is to seek out those companies that have superior qualities over the majority that can be measured through financial metrics such as gross margins (and the stability thereof), high return on equity and on capital invested, as well as managerial characteristics such as market-leading products and services, delivering on promises and execution on strategy and plans.

Some experts might take this one step further and also include something as intangible as 'corporate culture'.

Let's face it, a quality company led by quality management is not expected to issue a serious downgrade to forward guidance less than three months after reporting the business is back on track and the only way forward is through higher margins, revenues and profits, like what just happened with Integral Diagnostics (IDX).

Financial markets at times can be 'blessed' with a short memory, but those investors who own the shares on the basis of management's previous optimism have plenty of reasons to feel disgruntled and disappointed today.

Quality businesses also don't carry too much debt as that might impact on their operational stability and profitability. Having a strong moat helps with keeping margins stable and high.

Those who manage to continue to generate shareholder value over long periods of time know profitable investments, regularly executed, are but an essential part of the secret sauce that distinguishes the superior few from the low quality peers.

Quality companies are seldom the fastest growing in the share market, and neither will they ever be the cheapest priced, but they are usually adept in dealing with misfortune and challenges, always coming out on top given enough time.

And that, right there, at the end of the previous sentence is the biggest dilemma for today's investor: Quality does not by default distinguish itself through daily share price moves.

In the here and now, Westpac (WBC) shares can beat expectations and forecasts, and so can ANZ Bank (ANZ) and National Australia Bank (NAB), but their performances look pretty bleak when compared against CommBank's (CBA) over the past 10-20 years.

Owning Quality then becomes a matter of identifying the strong track record, trusting management at the helm, keeping the faith in their ability and qualities, and having a long-term horizon.

There's no uniform concept of what exactly is Quality, not in the share market, but it remains remarkable that whenever someone tries to identify the select few on the ASX, there's a lot of overlap with other selections and attempts.

Selections that come to mind include those released by Bell Potter, Morgan Stanley and Wilsons; selections that usually find their way into my writings when renewed or updated.

I've often remarked on the many similarities with my curated lists of All-Weather Performers in Australia.

"The Best Of The Best"

One investor recently published his Quality Top20 for Australia; the best of the best available through the ASX:

-REA Group (REA)
-Cochlear (COH)
-TechnologyOne (TNE)
-CSL (CSL)
-Pro Medicus (PME)
-Altium (ALU)
-Wesfarmers (WES)
-Car Group (CAR)
-Xero (XRO)
-CommBank
-JB Hi-Fi (JBH)
-Pexa Group (PXA)
-Lottery Corp (TLC)
-ResMed (RMD)
-Ebos Group (EBO)
-Dicker Data (DDR)
-ARB Corp (ARB)
-Computershare (CPU)
-BHP Group (BHP)
-Seek (SEK)

My main disagreement with that selection centres on Pexa Group, which seems to be lauded by all and sundry for its local near-monopoly in digital housing transaction settlements, but a costly and slow-going expansion into the attractive-looking UK market has eroded much of the company's halo since de-merging from the troubled Link Group (LNK).

Having a near-monopoly position in one market is definitely not good enough reason to be labelled High Quality. If it were, the number of companies carrying the label would be a whole lot higher.

For me personally, being part of the select few on the ASX means a company has the track record to earn inclusion, and for Pexa that is definitely not the case today.

I always think in terms of risk-adjusted returns when I shift focus to Quality and All-Weather stocks; the fact these companies have a proven track record of deliveries and success means the risk for heavy disappointment is considerably reduced.

A similar argument can be made against Lottery Corp, which was spun-off by Tabcorp (TAH) only in mid-2022.

Observations

The first observation to be made is a number of the selected companies are trading at or near an all-time record high, which by definition means they've achieved great rewards for loyal shareholders.

A second observation is that respective superiorities shine through when compared with similar companies over a longer period of time.

Shareholders in ARB Corp (ARB) might be feeling a bit let down post covid, but longer term returns still handsomely beat those from GUD Holdings (GUD) or Bapcor (BAP).

Domain Group (DHG) is only able to keep pace with REA Group during the boom times and while the local software services sector is welcoming a reborn Data#3 (DTL), it is but fair to say no company has ever come close to match the phenomenal trajectory of TechnologyOne shares on the exchange, including mini-look-alike Objective Corp (OCL).

Sonic Healthcare (SHL) is not represented in the above list but it too towers above Healius (HLS) -and Integral Diagnostics- in terms of quality characteristics and shareholder rewards.

And while many investors refuse to ever consider Aristocrat Leisure (ALL), there's simply no denying its superiority over smaller competitor Ainsworth Game Technology (AGI).

Aristocrat Leisure is also outperforming the international competition, which is an achievement the company shares with Altium, Car Group, Computershare, CSL, Cochlear, ResMed, and Pro Medicus.

It takes time and lots of luck and effort to become the global number one, but it takes many times over more effort, tenacity and successful execution to remain on top of the global competition.

This is why established global market leaders should be appreciated for what they are; special.

Unfortunately, as we've also witnessed with CSL and ResMed this year, Higher Quality companies are not 100% immune against the occasional disappointment or set-back. They are simply less likely to be seriously impacted by it, and mostly quicker in successfully dealing with it and recover.

Investors might want to keep this in mind now international shopping platforms Amazon and Temu are starting to make further inroads into Australian household shopping habits. A recent study has found both shopping apps are now the sixth and the first most downloaded shopping apps in Australia.

Combine this with the fact that middle and lower income Australians are under pressure to seek more value for their discretionary and non-discretionary dollars and we may well witness more pain and disappointment from those who are most vulnerable to changing spending habits in the months, if not years ahead.

Consumer Spending Is Changing: Winners vs Losers

Analysts of consumer-related stocks at Jarden have been warning for a while now the gap between winners and losers in the sector is about to widen. They've already spotted the first signals during AGM season indicating the winners may not remain completely unscathed, but the gap with the more vulnerable is likely to only widen further.

The first comparison that comes to my mind is between supermarket operators Woolworths Group (WOW) and Coles Group (COL). Too many investors still think of them as 'equals' for whom the pendulum swings favourably in alternate periods. What they are missing is that Woolworths is now the CommBank in this sector.

As it turns out, Jarden's analysis agrees with me with the latest sector update identifying Super Retail (SUL) and Woolworths as having the "best opportunity to re-rate via successful execution". Jarden equally appreciates Wesfarmers spending $100m on customer data, with $80m more to be spent in FY24.

It is this type of forward-looking investments that ultimately create the division between winners and losers in any sector.

Note companies including Endeavour Group (EDV), Accent Group (AX1), Coles and JB Hi-Fi (JBH) are equally increasing investment in data gathering and employment.

Who's Missing?

And now for the ultimate question: are there any companies that should be included in the above list instead of Pexa and Lottery Corp, and maybe even a few others?

There's always a level of subjectivity of course, and any Top10 or Top20 selection will always have its numerical limitation, but names that spring to my mind are Goodman Group (GMG), Macquarie Group (MQG) and Wisetech Global (WTC), alongside some of the names that had already been highlighted above.

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