•     Introduction: How to Define Quality?

•     Quality Persistence and Kailash’s Simple Quality Proxy

o     Return on Equity

o     Accruals

o     EBITDA Margins

•     Quality Performance

•     Conclusion: Kailash Core Models Work Best

Introduction: How to Define Quality?

In discussions with clients, we have found that while most investors feel like they know what quality is, reaching any sort of consensus on the optimal definition of quality can be elusive. When describing quality firms, investors like to talk about high and consistent profitability, healthy balance sheets, ample free cash flow (FCF), capable and trustworthy management teams, efficient capital allocation and robust economic models which benefit from durable competitive moats. However, the real difficulty emerges when trying to translate these concepts around quality from qualitative statements into dispassionate constructs that can be tested in an empirically robust manner. In many ways, fundamental practitioners seem to (knowingly or unknowingly) perceive “quality” in a manner similar to Supreme Court Justice Potter Stewart’s definition of obscenity who famously quipped, “I know it when I see it.”1 There are several dimensions of quality including management quality, balance sheet quality and earnings quality, among others, that may or may not be linked to each other. While these types of vague heuristics are common in many areas of equity research, we prefer to work with clearly defined metrics and then use history to test their validity and efficacy in predicting excess returns. Trying to convert general impressions of quality into “pure” quality metrics to help identify high quality stocks that will outperform and low quality stocks that will underperform within a future time period further complicates the debate on the optimal definition of quality.

Several prominent asset management firms have provided their general ideas of quality, their own optimal quality metrics and have even created investment products based on these metrics. These firms’ quality constructs range from simple univariates to complex formulas that often comingle items which we would classify as value factors. For example, some investment companies use a simple metric of profitability such as return on equity (ROE) as the categorical way of defining “quality” while others can include any of the following: ROE, ROA, debt/equity, earnings variability, total profits/assets, gross margins, FCF yield, FCF/assets and annual changes in any of these metrics. Not only do the variables used vary, but the calculation methodology can vary as well. Many firms use equations with the coefficients based on regression analysis, but other methodologies are more complicated. For example, Piotroski’s F-Score2 uses nine metrics to devise an integer scale from 0 to 9 in which one point is given for each of the metric conditions that are met: ROA > 0, operating cash flow (OCF) > 0, YoY growth in ROA > 0, OCF > net income (NI), lower long-term debt/assets than the prior year, higher current ratio than the prior year, no share count increase from equity issuance, higher gross margin and a higher asset turnover ratio than the prior year. The Piotroski’s F-Score was designed to be applied only to value stocks to determine which among the value stocks are the healthiest or have the highest quality. These few examples illustrate the wide diversity of approaches to the problem of optimally defining and measuring quality.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.



The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

October 8, 2014 |

Categories: White Papers

October 8, 2014

Categories: White Papers

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