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THE QUALITIES OF “QUALITY” AND THE USE OF ESG IN INVESTING
COMGEST ESG TEAM - ARCHIVED - 04-Jan-2016
INTRODUCTION
What is "quality"? In our view, “Quality is qualitative in nature”. I also think it should not be limited to gross and approximate yardsticks such as earnings standard deviation, a net debt/Ebitda ratio1 or even a slightly more elaborate Piotroski2 score. However, one could say that “Quality is determined by the durable competitive advantages of a business” and it can be measured by ROIIC3.
While I agree with this to a large extent, I would further posit that the “durable competitive advantages of a business are determined by its quality”. These relationships show how interconnected financial and extra-financial matters can be, which is why we decided to integrate environmental, social, and corporate governance (ESG) criteria / principles not only into our investment process, but also into our valuation framework.
In this paper, I will try to address what quality is at its core, while likewise illustrating ESG methods to measure it. But I should start with a disclaimer: first, not all of our investee companies possess all of the “qualities of Quality” presented hereafter; and second, the challenge in defining quality is that it is a very subjective concept, just like beauty. As such, one can safely say that, in the end, “quality is in the eyes of the beholder”4.
According to Merriam-Webster, the definition of quality is obscured by the plurality of its meanings. In trying to keep things as simple as possible, two main ideas convey the notion of quality: an essential characteristic on the one hand and a degree of excellence on the other.
QUALITY EMERGES WHEN PURPOSE MEETS THE NEED FOR A SOLUTION
Less dry than a dictionary, but just as enlightening, UNESCO states “Quality is a measure of fitness to purpose”.
A third definition, from the American Society of Quality, refers to the “Pursuit of solutions contributing to successes, fulfilling accountabilities and satisfying stated or implied needs”. Stemming from the Latin word “qualis”, which means “of what kind”, the quality of a business can be defined by its singularity, as well as its specific purpose and its ability to fulfil it within its social ecosystem.
When we at Comgest talk about the “pricing power”, the earnings visibility or the exceptional franchise of a company, we are definitively talking about the quality of a business, which largely depends on the relevance of its specific purpose.
This paper was originally written in 2016 and has not been updated since publication.
FOOTNOTES:
1 Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a measure of a company's overall financial performance and is used as an alternative to simple earnings or net income in some circumstances
(http://bit.ly/34snoNF).
2 Investopedia. “ Piotroski Score” (http://bit.ly/1SyHV3W).
3 Return on incremental invested capital (ROIIC) is an extension of return on investment capital (ROIC), which is itself an extension of return on investment (ROI) (http://bit.ly/2Xrj7by).
4 To best understand “quality” read Robert Pirsig: Lila (1991) and Zen and the Art of Motorcycle Maintenance (2006), in which he writes: “The process of philosophic explanation is an analytic process...of breaking something down into subjects and predicates. What I mean...by the word ‘quality’ cannot be broken down into subjects and predicates. This is not because quality is so mysterious but because quality is so simple, immediate and direct”. I would add that the best definition was given by my own grandmother: “I know it when I see it”!
