Quality Company Metrics

The first step in my investing strategy is to identify quality companies.  There are approximately 2000 companies listed on the ASX, and I only want to invest in the top handful - and even then - only when they are cheap.   But back to step 1, I'd like to walk you through how I identified the few companies at the top of the list.

I started by downloading all of the relevant company financial data from Comsec.  Note that this was not the price history for the companies, but each company's financial reporting history.



I then rated each company according to 4 criteria:

• Earnings Quality
• Debt Management
• Equity Efficiency
• Retained Earnings Management

and then created an overall ranking based on weightings of the above criteria.

Earnings Quality

For earnings quality, I used 3 earnings related metrics:

• Consistency
• Rate of Increase
• Data Set Length

So, basically, I was trying to identify companies that had a long history of solid earnings growth.  I then combined all of those factors to come up with a number between 0% and 100% - 0% being a company that I should not consider, and 100% being a great company.

Debt Management

For debt management, I used a similar rule to Buffett's.  That is, a company has healthy debt position if it could use all of its earnings to pay off its debts within 2 years.  So, any company that was in that position I gave 100% to, fading out to 0% if it would take a company 10 years or longer to pay off its debt.

Equity Efficiency

For equity efficiency, I used the average ROTC (Return on Total Capital) and ROTE (Return on Total Equity) over the past 10 years, and gave 100% for any company that averaged 20% or more, and 0% to any company that had 0% or less.

Retained Earnings Management

For retained earnings management, I was trying to assess how well the company used their retained earnings to grow their future earnings, or, in other words, how well the company behaved like a compounding engine.

Results

Here are the top dozen or so companies identified by the above process:

Results Disclaimer

Most of these companies are known to be very good companies, and so this has already been factored into their current market price, possible factored in too far, and so some represent really poor investment opportunities at current prices.

More so, these companies are yet to pass the manual review step, where I look at future plans, and also ask whether the last 10 year's performance is indicative of the next 10 year's performance.

Next Steps

Shortly, I'll post about how I measure the "cheapness", or lack thereof, of any of the companies in this list...