Warren Buffett has often summarized key investing lessons in just a few words.
In his 1989 Berkshire Hathaway letter to shareholders, he outlined the importance of buying quality companies:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
In just 20 words, Buffett recapped a lesson from his business school professor — Benjamin Graham.
In the 1973 edition of his book The Intelligent Investor, Graham wrote about accountants’ impact on earnings.
To illustrate his point, Graham asked readers to consider two companies, both in the steel industry. In this example, Company A and Company B each incur a significant expense of $100 million on equipment upgrades.
Remember, Graham wrote this in 1973, so that’s equivalent to a $763 million expense today.
Now, Company A has decided to write off the entire $100 million as an expense in the current year. This conservative approach, while financially sound, drastically reduces the company’s reported profits for that year.
On the other hand, Company B chooses to spread this expense over 10 years, amortizing $10 million each year. Consequently, Company B’s reported profits appear more robust in the short term.
Graham explained that the first scenario mirrored what U.S. Steel did. By writing off expenses immediately rather than amortizing them, U.S. Steel reported lower short-term profits.
For an uninformed investor, Company B might seem more profitable and financially stable than Company A, based solely on reported earnings.
However, in reality, the difference lies merely in accounting practices, not in actual business performance.
Since then, analysts have worked on quantifying Graham’s example. They’ve developed measures to define what’s known as the quality of earnings.
What Quality Investors Like to See
Investors have found that high-quality earnings are worth more than low-quality earnings.
That’s because companies with high-quality earnings tend to deliver better long-term results. This is often reflected in long-run gains on their gains.
Quality metrics are more difficult to calculate than popular investor benchmarks like the price-to-earnings ratio.
For example, the accruals ratio compares the difference between net income and cash from operations to total assets.
Quality investors prefer to see low accrual ratios. High accruals relative to total assets can indicate that a significant portion of earnings is not backed by cash, suggesting potential manipulation or non-sustainable earnings.
Analysts also consider the ratio of cash from operations to net income. This is known as the cash conversion ratio (CCR).
A CCR close to or greater than 1 indicates that earnings are well-supported by cash flows, reflecting higher earnings quality.
Graham’s example underscores a crucial lesson: Investors must delve deeper into financial statements to understand the accounting choices companies make.
That’s because these practices can significantly affect reported earnings, potentially misleading investors about a company’s true financial health.
Unfortunately, this type of analysis can be quite time-consuming for many individual investors. But good news is that there’s a shortcut at your fingertips…
An Easier Way to Find High-Quality Companies
Adam O’Dell’s Green Zone Power Ratings system considers Quality as one of the six factors used to assign ratings to stocks. Adam designed the ratings to minimize risks and maximize returns.
He included quality in the ratings because, as many academic studies have shown, high-quality stocks (i.e., stocks that rate 80+ or above in Green Zone Power Ratings) can increase a portfolio’s performance.
And Adam combines five unique metrics to ensure he’s measuring quality correctly.
Adam’s rating system follows a complex calculation that combines multiple factors of both the stock and the company.
His research has proven that stocks rated above 80 overall on his 100-point scale beat the S&P 500 3X over the past 23 years.
You can check the quality score for any stock (as well as the overall ratings) by entering the stock ticker in the Green Zone Power Ratings search bar right here.
Until next time,
