Tips for Choosing a Quality Company


Although each investor may have a different definition of a quality company, research has shown that several quality factors have a greater impact on stock performance. These quality factors can mostly be found in a company’s annual report, such as return on invested capital, return on equity, debt to equity ratio, accounting quality, gross profitability, and EPS growth. In summary, companies with high barriers to entry (reflected in higher return on invested capital and return on equity) and the ability to generate cash flow (reflected in good accounting quality, lower debt to equity ratios, higher gross profitability and EPS growth) typically have better stock performance.

Of course, the above research is based on statistical correlations and is not a definite or unchanging rule. During times of quantitative easing by central banks, even poor-quality companies may have the best stock performance, as seen with the surge of meme stocks in 2021 and early 2022. Additionally, investors may be willing to tolerate negative cash flow for a relatively longer period of time when emerging technology companies are building their own competitive strengths in new industries, such as with Amazon.

Currently, global central banks are tightening liquidity, and investors exhibit lower tolerance for risk. As a result, companies that do not conform to the abovementioned quality factors may experience significant price pressure.

This was evident in the recent targeting of an Indian conglomerate by short-sellers in early February. Despite its highly diversified portfolio, which includes a range of businesses from airports and data centers to mining and national defense, the company’s primary focus is on traditional industries. Nevertheless, over the past five years, the company’s stock price has skyrocketed from just over 100 rupees to more than 4,000 rupees, making its founder one of the richest men in the world.

The short-sellers accuse the company of manipulating its stock price through complex structures. The veracity of these allegations is difficult to confirm, but we can try to analyze the company’s annual reports with the abovementioned quality factor framework to get more informed on the issue.

While profit inflation is common in annual reports, manipulating cash flows is more challenging. Therefore, we can start with looking into the company’s cash flows. Over the past two years, the company’s operating cash flow was only 54 billion rupees, far below its investment cash requirements of 250 billion rupees. Most of the required funds came from bank loans, resulting in the company’s borrowing amount soaring to over 400 billion rupees, approximately 1.5 times its capital, which is relatively high. However, the company’s shareholder return rate is only 2.9%, which is exceptionally low, and the annual return rate is insufficient to support the company’s rapid expansion.

From a valuation perspective, the company’s stock price has skyrocketed over the past five years. Unless there are significant changes in its business, it is generally difficult to support such rapid growth in stock prices. Despite a decline of more than 50% in its stock since the beginning of January, the company’s price-to-earnings ratio (based on its earnings in 2022) remained over 200 times by mid-February, far higher than other traditional industry companies. At the same time, the company’s price-to-book ratio was 9.3 times, while the Hang Seng Index’s price-to-book ratio was only 1.2 times by then.

We primarily invest in Chinese stocks and are not experts on India. Our research on Indian companies is limited to analyzing their annual reports. Relying solely on annual report data has its drawbacks, as other competitive advantages of the company may not necessarily be reflected in the numbers over one or two years, such as their execution capabilities and political-business relationships. However, analyzing these quality factors along with the current performance should also provide insights for investment.


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.