Musings with Analyst – October 2022

Let us take a deep dive into Windmill Capital’s proprietary quality scores. We use these scores extensively during creation and rebalancing of smallcases to weed out poor quality companies. 

A factor is a broad and persistent driver of stock returns. For example consider the capital asset pricing model (CAPM):

where;

Ri – stock returns, Rf – risk free rate of return, Bi – beta, Rm – return of market

The model states that the beta or returns of markets drives stock returns. So here market return is the factor. Very similarly there are other factors such as value, momentum, growth etc.  

While the “Quality” factor has its root in fundamental analysis and has been around for some time, issues such as the Enron scandal, revived interest in it. A major drawback of this factor is that there is no consistent definition of what is considered quality.  

The Windmill Capital team, after intense research, created the proprietary quality score. We used 4 pieces of financial information to calculate the score:

• Management Effectiveness is determined using Return on Equity (ROE)%
• Financial Strength is evaluated using the Debt/Equity ratio
• Earnings quality is estimated using an accrual ratio ((Net income – Free Operating Cash Flow) / Total Assets)
• Consistency in performance is gauged through earnings variability over the past 5 years.

When calculating quality scores for banks and NBFCs we use capital adequacy ratio instead of gearing ratio. In case of insurance companies, gearing ratio is substituted by insurance leverage ratio. 

Based on the quality score, companies can be assigned to any of the 4 quartiles. Companies in quartile 1 (Q1) are the best and so on. The below chart displays the sector wise quartile breakup of quality score.

Information technology (IT) and consumer staples sector has the highest proportion of quartile 1 companies. 83.3% of all IT companies are in Q1, while the proportion is 47.4% for consumer staples companies. Consumer staples broadly consists of FMCG companies and entities that sell alcoholic beverages, sugar, packaged food & meat, tea & coffee etc. Real estate and utility companies have the highest proportion of Q4 companies. Utilities usually consist of companies involved in power generation, power infrastructure, power transmission & distribution, gas distribution etc. 

A quick look at the break up of the constituents of quality score will explain this phenomenon. Utilities and real estate companies tend to have a lot of debt on their balance sheet. The median debt to equity (D/E) ratio of these 2 sectors are 74.7% and 49.0%. High debt results in high interest costs and this eats into the profitability of these companies. As a consequence, the median ROE of these sectors is just 13.7% and 4.15%. On the contrary, IT and consumer staples companies have a median D/E ratio of just 10.4% and 14.3%. This results in high ROE. Median ROE of these sectors is 21.6% and 17.2% respectively. A combination of low debt and high ROE assists IT and consumer staples companies getting high quality scores.