What is Quality?
Does "Quality" of management, earnings, and products give rise to a "Quality" investment? By Benjamin Tan
The book Zen and the Art of Motorcycle Maintenance: An Inquiry Into Values is a narration of a summer motorcycle trip undertaken by a father and his son. It is not just a novel but a penetrating examination of numerous philosophical questions.
Halfway through this book, I am intrigued by the contentious concept of "Quality.” Specifically, two lines have stuck in my head:
“How are we supposed to know what quality is?”
“…even though Quality cannot be defined, you know what Quality is.”
While the “Quality” discussion in the book is not related to investing or business, I cannot help but wonder about its applications in stock picking.
Quality Investments: Only in Hindsight?
To make this post more focused, I shall stick to consumer-related companies.
Within that space, we can agree that some of the most successful companies include Nike, Apple, Amazon, Costco, Tesla, and Netflix. They have all grown by orders of magnitude in terms of earnings, scale, cultural impact, fandom, and of course, share price.
However, before arriving at their vaulted positions, they all went through growing pains. Apple AAPL 0.00%↑ struggled with topline concerns when Buffet took a stake in the company. Tesla TSLA 0.00%↑was in “production hell” when it tried to ramp up Model 3 at Fremont and almost went bankrupt. Netflix NFLX 0.00%↑ had multiple near-death episodes throughout its corporate history, as chronicled in the book, That Will Never Work, authored by its co-founder, Marc Randolph.
In the eye of the storm, few would have been able to discern “Quality” amidst missed earnings, social media chatters, negative headlines, production delays, and intense cash burn.
Unpacking Quality
Seasoned investors, whether retail or institutional, have probably reviewed enough companies to know (at least on some subconscious level) what a quality stock should be. Borrowing from the list of exemplary companies above, one may infer the following to be some of the critical characteristics of “Quality”:
Products and services enjoying customer loyalty and renewal thereof with each generation of consumers
Strong cost controls and capital discipline
Growing total addressable market through continual additions to product and service line-up, plus international expansion
Some investors like to use quantifiable traits like minimum revenue growth or profitability to qualify for “Quality.” While the approach is sound, that logic may break when a company undergoes financial turbulence, as did giants Amazon AMZN 0.00%↑ and Meta META 0.00%↑ in recent quarters for different reasons.
Conversely, we probably know what low-quality means, primarily by studying cautionary tales. Peloton crashed and burned after mismanagement of hypergrowth discombobulated its operations to the point where the new CEO Barry McCarthy had to completely reverse its vertically integrated strategy and raise rescue financing.
Another example of a low-quality but hyped stock is Allbirds BIRD 0.00%↑. The company has been in the news for its lackluster financial results, burning through cash and struggling with waning demand. For a brand so early on its expansion track, Allbird has (so far) failed to live up to its promise.
Quality is Earned Over Time?
“You never know who's swimming naked until the tide goes out.”
Warren Buffett
To be a “Quality” company, it must first endure. It is useless to have all the trappings of a successful corporate in the making if it cannot survive recessionary pressures or a hostile capital market.
For example, in the face of growing competition and a weakening economy, Tesla slashed prices to boost demand and keep its Giga factories running at full speed. But thanks to its established branding, customer goodwill, and balance sheet strength, it still generated near-record cashflows and sustained considerable investments into additional Giga factories and the production ramp of Cybertruck and Semi.
In contrast, the chances of Lucid LCID 0.00%↑ enduring as a standalone enterprise look bleak, with its suboptimal production scale, rapid cash burn, and weak balance sheet. Along with EV peers at early (and costly) stages of expansion, these newbies cannot be considered “Quality” companies until they survive multiple storms.
Conclusion: Quality and Proven Resilience may be Inseparable
I may therefore deduce that the longer a company has been thriving (and exhibiting hallmarks of a well-run enterprise) over multiple economic cycles, the higher its “Quality.”
Quarterly numbers may display choppiness, but proven resilience over many years (or decades) is perhaps the closest indicator of “Quality” when reviewing investment opportunities.
I think we all know it.
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