In prior posts we have outlined a few of the core pillars that shape the Richie Capital Group investment framework, including the advantages of managing a concentrated portfolio, the benefits of investing in smaller companies, and the importance of holding investments for the long run. These elements define the RCG philosophy and have been foundational to our performance. In this post, we will explore another key pillar: investing in high-quality businesses.
While we do not subscribe to any one “style” of investing, our investment philosophy leans significantly toward identifying and investing in quality businesses. We believe that, over time, our unique approach to identifying and analyzing quality businesses offers significant advantages for generating strong returns, especially when combined with the other elements of our investment framework. Focusing on quality can often make up for concerns in other areas, such as a slightly above average valuation. As Benjamin Franklin wisely asserted, “The bitterness of poor quality remains long after the sweetness of low price is forgotten.”
The Case for Quality Outperformance
Research has consistently demonstrated that, over the long term, high-quality businesses tend to outperform their peers[1],[2]. This outperformance is grounded in several factors. First, quality companies often possess strong, durable competitive advantages—what many would refer to as a “moat.” These advantages allow such businesses to maintain market leadership, higher margins, and reinvest in attractive growth opportunities, thereby compounding value for shareholders over time.
High quality businesses typically possess stronger balance sheets, higher returns on capital, and better management. These factors contribute to a quality business’ ability to navigate unexpected challenges and grow steadily. Finally, quality businesses also tend to exhibit lower volatility during economic downturns, as their robust fundamentals allow them to better withstand financial shocks. This downside protection is an important aspect of long-term investing, as it minimizes permanent capital losses.
The MSCI Quality Index has historically generated excess returns over the long run with a +2.1% annual excess return over the MSCI world Index since 1999:
The quality factor is especially pronounced when applied to smaller market caps where companies with high-quality attributes tend to outperform their lower-quality peers by a wide margin[3]. This is particularly relevant for RCG, as we focus on smaller, under-the-radar companies that are either already high-quality or are on a trajectory towards becoming so. Identifying these businesses early provides us with a significant opportunity to generate outsized returns. We are certainly not the first investors to recognize the value of focusing on quality. However, our approach to defining and identifying quality was developed over decades and sets us apart.
Defining Quality
Unlike traditional investment factors such as value (often measured by price-to-earnings or price-to-book ratios) or growth (measured by revenue or earnings growth), quality is a more nuanced and multifaceted concept. There is no single metric or screen that can universally define a quality business. Various definitions have been reviewed by academics[4], and many practitioners have offered their interpretations. For instance, GMO’s well-known interpretation of quality can be summarized as companies with “high returns, stable returns, and low debt.[5]” However, broader definitions often fail to capture the full picture. At RCG, we view quality as a mosaic of both quantitative and qualitative attributes that require careful analysis and judgment. We believe that our decades of real-world experience analyzing companies through a variety of lenses (financial, strategic, operational) have provided us with pattern recognition abilities that sets our process apart from others.
From a quantitative perspective, several financial metrics help us identify companies that may exhibit quality characteristics, all of which have been proven to be robust predictors of superior risk adjusted returns[6]. These include high return on invested capital (ROIC), consistent free cash flow generation, and stable or growing margins. Companies that can demonstrate sustained cash flow generation and efficient use of capital generally indicate a level of operational excellence that we associate with high-quality businesses. These metrics help us understand a company’s recent performance and provide some insight into its near-term prospects.
Popular Quality Factor Indexes, Definitions, and Degrees of Robustness
“What is Quality” Hsu, Kalesnik, Kose, 2019
While quantitative metrics help us understand a company’s recent performance and near-term outlook, these serve as backward-looking indicators. It’s the qualitative factors that are critical for assessing a business’s long-term potential. The “qualitative attributes of quality” are often more subtle. Our more nuanced approach is designed to assess factors that are less tangible, but we believe to be highly predictive indicators of long-term success. These include the strength of a company’s management team, its corporate culture, relationship with employees and customers, competitive positioning within the industry, and its ability to innovate and adapt to changing market dynamics.
We consider how management communicates with investors, especially during challenging times. Sometimes even a small bread crumb of information can provide a treasure trove of clarity on why a business is successful. A specific example being when the CFO of one of our portfolio companies told us they decided to turn down business from a large U.S. based EV manufacturer due to concerns with how that company treated their employees. Management believed that contractors (our portfolio company’s employees) would likely not be treated much better. This told us everything we needed to know about management’s approach to maintaining a happy and motivated workforce. These types of insights cannot be captured in an excel spreadsheet or financial model but are critical in assessing a company’s long-term viability.
The Role of Active Management in Quality Investing
Quality investing is not simply identifying companies with good metrics; it is about understanding the underlying drivers of those metrics and evaluating their long-term sustainability. This depth of analysis lends itself well to active management, where a deeper understanding of the companies and industries allows us to make more informed decisions.
The dynamic nature of quality also means that it is a moving target. A company that is high-quality today may not be so tomorrow, depending on its ability to maintain its competitive advantages, adapt to market changes, and continue executing effectively. Active management allows us to monitor these factors closely and adjust our portfolio accordingly, ensuring that we remain invested in companies that are positioned for long-term success. It is here that active managers, like RCG, who dedicate time to understanding both the quantitative and qualitative facets of a company, can differentiate themselves. Quality takes time to assess—it requires judgment, experience, and often a willingness to look beyond short-term market trends.
Conclusion
Investing in high-quality businesses is a central pillar of RCG’s investment framework, and one that has been supported by both research and experience. While not easy to define, quality has proven to be a powerful driver of long-term outperformance, particularly when combined with the other elements of our investment framework. Our approach blends quantitative rigor with qualitative insights, allowing us to identify companies that not only have strong financials but also possess the intangible characteristics necessary for sustained success. In doing so, we believe we can continue to generate strong, risk-adjusted returns for our investors over the long run.
–Eric D. Crown
[1] “Quality Minus Junk” Asness, Frazzini, Pedersen, 2017.
[2] “Are Cash Flows Better Stock Return Predictors Than Profits?” Foerster, Tsagarelis, Wang, 2014
[3] “Size matters, if you control your junk” Asness, Frazzini, Israel, Moskowitzm Pedersen, 2018.
[4] “Quality Investing” Novy-Marx, 2012.
[5] “Profits for the Long Run: Affirming the Case for Quality.” Joyce, Chuck, and Kimball Mayer. 2012. GMO White Paper.
[6] “What is Quality” Hsu, Kalesnik, Kose, 2019
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