Coronavirus - we're here to help
From how to access your account online, scam awareness, your wellbeing and our community we're here to help.

Skip to main content
  • Register
  • Help
  • Contact us
  • Log in to HL Account
What Does Quality Look Like?

HL SELECT UK GROWTH SHARES
HL SELECT UK INCOME SHARES
HL SELECT GLOBAL GROWTH SHARES

What Does Quality Look Like?

Managers' thoughts

Important information - The value of this fund can still fall so you could get back less than you invested, especially over the short term. The information shown is not personal advice and the information about individual companies represents our view as managers of the fund. It is not a personal recommendation to invest in a particular company. If you are at all unsure of the suitability of an investment for your circumstances please contact us for personal advice. The HL Select Funds are managed by our sister company HL Fund Managers Ltd.
Steve Clayton

Steve Clayton - Fund Manager

10 June 2020

Investing in the stock market is a fundamentally risky business. Wars, pandemics, recessions and straightforward corporate mistakes can all damage or destroy an investment’s value. Even the best-managed businesses can face challenges that hold them back. As Fund Managers and Analysts the HL Select team focus on seeking out quality businesses because we know all of these things can, and eventually will happen. Well-built and well-managed companies are better placed to withstand these challenges and to capitalise on the weaknesses of others.

We don’t seek out exciting prospects where a turn of luck could transform the business. We look for companies that will just grind out dependable results year in year out. So what does a quality business look like? The simple answer is that none of them will look exactly the same as each other, but they do share qualities. Remember, this article is not advice to buy, sell or hold any particular investment. If you are unsure if an investment is suitable for you, please seek advice. All investments rise and fall in value, so you could get back less than you invest.

Perhaps the most important quality we look for is a degree of conservatism in the way the business is structured and managed. Big deals can bring high rewards, but businesses that borrow too much at the wrong time can cost investors dearly. We look for companies that will always keep their finances robust so that they are not blown off course in recessions. We want managements that look before they leap, that gauge risks carefully and structure their businesses to be capable of weathering storms. Taking the long-term view matters hugely. If a business does that there’s every chance that it will keep itself properly resourced and prepared for changes coming down the line. A great example here is to look at Next, which embraced e-commerce early, in scale, compared to Debenhams, whose online sales never got anywhere near enough to shift the dial. Next has delivered returns of almost 1,400% over the last twenty years. Debenhams is bust. As always, past performance isn’t a guide to future returns.

Conservatism is not just about the balance sheet, it’s also about stopping the business becoming over-dependent on anything which management cannot control. Too few customers and a change of heart by one or two of them can hurt. Achieving security of supply for the inputs you need is critical too. Ideally businesses should aim to be indispensable to their customers, but able to pick and choose their suppliers. Achieve that and you can have pricing power and cost control at the same time.

It’s better to wake up knowing that business will come in today, rather than be fretting about where the next sale will come from. We think businesses with repeat revenues are higher quality than those without. And the greater the underpinning of those repeats the better. We love subscription businesses, where there is an agreement to keep taking the product, stretching out into the future. As an example, we hold Relx across our fund range largely because so much of its revenues come from research subscriptions by universities and research institutes that operate on budgets almost independent of the state of the economy.

We see the profit margin a company makes as a vote by its customers upon the quality of what it does, and the ease of finding the same elsewhere. So we like to see fat margins, allied to strong returns on capital. After all, if you achieve both, there’s every chance that you will be generating strong cash flows. Companies have just had a rather brusque reminder that cash is indeed king. With so many losing some or all of their revenues due to lockdowns those that had the cash reserves to just hunker down and pull through have still been able to pay dividends to their investors. Those who fell back upon the state for furlough support cannot reward shareholders too. So margins, returns and cash flows are all vital parts of the quality picture.

If you can find all of these qualities in the same place, you are well on the way to identifying a quality investment. But so far, we haven’t even begun to consider what the company does. Corporate history is littered with the ghosts of once great businesses that time passed by. The highest-quality businesses will evolve to keep succeeding as societies and technologies change. Microsoft has maintained its lead in desktop operating systems, office software and gone on to develop a leading position in cloud computing and video gaming, markets that did not exist when the company first rose to prominence.

Unilever’s portfolio of brands has changed over the years, but many names are constants throughout. The company has kept investing in keeping them fresh and relevant to consumers worldwide. This ability to evolve is what sets it apart from the pack. So many brands have fallen by the wayside, but Unilever has morphed the portfolio, changing focus, adapting and anticipating trends. It’s another quality name that we hold across our range of HL Select funds because it has proven dependable for decades.

For us, the sweet spot in the market is the tiny group of high quality, dependable growth businesses that have that unique ability to grow, year after year, only taking minor stumbles even when others are falling over. We believe they can compound value over the long run and build wealth for their investors in a more dependable fashion than any other type of investment – though as ever, there are no guarantees.

Important - This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information. Unless otherwise stated performance figures are from Bloomberg and estimates, including prospective yields, are a consensus of analyst forecasts from Bloomberg. They are not a reliable indicator of future performance. Yields are variable and not guaranteed.