To make Wealthtender free for readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a conflict of interest when we favor their promotion over others. Read our editorial policy and terms of service to learn more. Wealthtender is not a client of these financial services providers.
➡️ Find a Local Advisor | 🎯 Find a Specialist Advisor
[Our innovation thought leadership interviews regularly explore the ongoing evolution happening in investment and risk management, but we also take deep dives into “niche” investment areas or specific strategies to learn from experienced managers with unique perspectives. We feel it is critical, in such a rapidly changing industry environment, to continuously re-examine and learn from different investment approaches and ways of thinking.
To that end, I feel it is time to review the perennial discussion on “quality” investing and focusing on “quality” companies. There are so many questions and qualifications around that word and the investment concepts or principles they refer to:
Does the investment designation of “quality” signify certain company operating absolutes or, in the real-world, does it refer to more of a broad range of characteristics and exhibit varying shades of gray? What is a good way to identify companies that truly meet the litmus test of “quality”? How is the competitive landscape of managers approaching and executing this investment strategy differently? How do sophisticated professional investors, including financial advisors, consultants, and due diligence analysts, wrestle with the connotations of the word and the implementation of an investment process around it? Also, how do those parameters around “quality” hold up against a cross-industry backdrop of rapidly changing business environments that history may have no guidance for?
To explore the mindset and execution of this investment methodology more fully, we were introduced to John Crawford, IV, Managing Director of Equity Investments for Crawford Investment Counsel – an Atlanta-based, independent asset management firm founded in 1980 that has focused on high-quality companies with a strong commitment to dividend payments to shareholders. We asked him to share his firm’s four decades of investment experience, research knowledge, and portfolio construction methodologies focused on quality companies.
In hearing their investment approach and experience with their clients, I sense a strong behavioral finance component at play here as well. I am reminded that even at a time of rapid change and growing complexity, explaining and executing on a simple, common-sense strategy can potentially be the most engaging.]
Hortz: How do you define what is a “quality” company?
Crawford: Quality is typically a subjective measure. While we all aspire to quality – and hopefully in all aspects of our life – in the investment business, it is typically measured with three criteria: financial strength, business consistency, and profitability. The most basic measures of those three criteria when it comes to stocks are balance sheet strength, earnings per share variability, and return on equity (ROE). Our portfolios skew high on both ROE and balance sheet strength, and skew low on earnings per share variability, which is a measure of consistency or predictability.
We do not have absolute levels for those different criteria that we seek to satisfy or that we mandate. Every company has its own optimal capital structure. Each business has different reinvestment requirements, end market exposures, and other factors to consider. So, there is not an across-the-board level that you can state. In some respects, “quality” is a relative term, whether you are looking at large cap stocks, small cap stocks, whatever.
Within the large cap universe, we believe the highest quality component of that is comprised of companies that have paid a dividend for 10 years. When you look at balance sheet strength, business consistency, and high ROE, guess what pops up like mushrooms around all those criteria? Dividends, and not just dividends, but usually rising dividends. There are some companies that “fit that bill” that do not pay dividends, but for the most part, you are going to find dividends associated with those “quality” criteria.
Hortz: What is the approximate size and nature of this universe of stocks?
Crawford: In the large cap space, we have determined about 350 companies that meet that criteria and have paid a dividend consistently for at least 10 straight years. We view the 10-year time horizon as meaningful because it spans a full business cycle, effectively screening out more cyclical and economically sensitive companies. A very high percentage of these companies have not just paid dividends for 10 straight years, they have also increased their dividend in most, if not all, of those years. You can ask if there is anything unusual about that, but I would say that is pretty unusual as rising dividends represent approximately 65% – 70% of those companies.
That tells you that once companies get into this “quality” universe, they have some really special characteristics, traits, and tailwinds to their business; not just from an economic standpoint, but they also have a propensity and a willingness to pay that dividend and return capital to shareholders. They are aligned with shareholder interests, and they reward shareholders through not only dividends but also share buybacks once they have reinvested back into their business, which obviously we need to see in order for the enterprise to profit and prosper over the long term.
In the small cap space, we reduce the dividend requirement to a preference for three years of consistent dividend payments, resulting in a broader universe of around 750 companies. While the relative quality of this broader universe is not nearly as high, our small cap strategy actually has quality characteristics similar to those of large cap stocks. The ROE is not quite as high as it is in large cap stocks, but earnings per share variability and balance sheet strength are comparable.
Hortz: What specific research criteria and selection process do you further apply on these quality companies to get to your high-conviction, “best ideas” portfolios?
Crawford: As you might expect, as a fundamental long-term oriented investment firm, we do all the traditional balance sheet, income statement, and cashflow statement analysis. We read all the company disclosure presentations, industry information, et cetera. This is all fairly typical for any fundamental firm, but we have internally developed a number of tools that we use that work particularly well with higher quality stocks.
Examples of this at a very rudimentary level would be that some of the screening we do is unique to higher quality stocks. But beyond that, we have a total shareholder return algorithm, what we call our “TSR framework”, which essentially is our version of price targets and it solves for how we expect to get paid from each component of the profit equation. So fundamental progress, valuation improvement, plus yield – it incorporates all those. We use a three-year horizon, and it works particularly well for higher quality stocks because the businesses are more consistent. The quality and consistency of the companies we invest in provide better visibility so the range of outcomes is narrower and the likelihood of success is better.
We also have a rating system that is designed to communicate to our team our conviction level on valuation, fundamentals, and overall rating so that everybody knows what the value proposition is on each company. We believe these measures help us optimize our company selection process.
Hortz: What kind of research process do you apply on the nature and quality of the dividends that companies distribute, especially as you have different dividend growth and dividend yield portfolios?
Crawford: We look very closely at companies that not just pay a dividend, but also those with dividend sustainability and an ability and willingness to increase it. We do not want to buy a company and have a dividend cut occur. You get into trouble when you reach for yield too much, or you buy a business where the yield comes along with some other factor that manifests in a risk to the company. It might be commodity price risk, or credit risk, or reliance on the capital markets to fund their operations. Or maybe there is interest rate risk, whatever it may be.
That due diligence and research process has resulted in very few dividend cuts in our portfolio over the 45 years we have been in existence. And so, we are analyzing company dividends paid out depending on the portfolio objectives of dividend yield versus dividend growth, as you referenced. We obviously are seeking companies with sound capital allocation policies, so we look at management alignment with shareholder interests.
An interesting point to make here is that what we really like is what the dividend signals to us and what that rising dividend signals to us, which to us is a tangible statement from the board that says, business is good, it is getting better, and the future looks bright. There is a great deal of effort that goes into this – we have a rigorous, time-tested process that includes significant foundational work and in-depth fundamental analysis – but it starts with that basic gesture, and as an owner of a business, we expect to get paid something out of the profits.
Hortz: How does this differentiate your approach from other quality and dividend-focused investment managers?
Crawford: Not paying a dividend is non-negotiable here at Crawford. Every company we have ever bought pays a dividend. Sometimes you get equity income strategies that say 80% of the companies have to pay dividends. Well, ours is a hundred percent. So that is a differentiator.
We are also price sensitive, value-oriented investors, while some dividend growth investors are not value-oriented. We are at the intersection of quality and value, and as a result of that, you get upside participation with well-run quality companies, but the insistence on dividends provides valuation support that protects you in down markets. I do think that is an attractive by-product of what we do.
Hortz: How do you apply your investment approach in each of your focus strategies? Do they have differentiated dividend-focused frameworks?
Crawford: A number of our investment strategies are objectives-based. Our Dividend Yield strategy has to have a yield in that eighth or ninth decile of all dividend paying companies, and we have pegged it at a minimum of around four percent. We have a requirement for income in that strategy as we do in our Managed Income strategy. When you move into the smaller cap strategies like our Small Cap strategy, you move down the cap spectrum, and the dividend or yield becomes much less important there. And the dividend is really a signal of quality, an indicator of business strength and alignment of management with shareholder interests. They do have differentiating frameworks.
We run different screens to help us identify candidates for different strategies and some stocks are owned in more than one strategy. I would say our Dividend Growth strategy is more of a quality portfolio where we are seeking attractive levels of free cash flow trading at a reasonable valuation with good visibility on future growth. When we move to the small cap space, what we are looking for there is to exploit the information advantage, but also capitalize on the quality premium that exists in small cap stocks. You want that tailwind of dividends and quality when you move down the cap spectrum.
Hortz: Can you walk us through a company example or two high-conviction quality companies?
Crawford: A good example is Johnson and Johnson which is a textbook example of consistency. Whether the economy is in a recession or expansion, you are going to take your medicine. The company has paid a dividend and grown it every year for 65 straight years. They have one of the few remaining AAA balance sheets, an ROE that is somewhere in the 30% range, the dividend yield is around 3%, and the stock trades at around 16 times earnings.
In the small cap space, the example I would give you is WD-40 company which is a single product company we all are familiar with and use. The company has extremely high margins, low earnings variability, rock solid balance sheet, a well-run business that is aligned with shareholder interests, and they are still expanding their footprint geographically overseas while announcing a few ancillary products that might prove to help with sales growth. The stock’s not cheap, but you often do not get really blue-chip quality merchandise in the small cap space at deep discounts. This one fits with our theme of quality at a reasonable price, which is where we think WD-40 falls today.
Hortz: What suggestions can you share with advisors on how to position and explain this investment strategy to their clients?
Crawford: I think our investment philosophy, as we explained previously, is looked at as a “sleep-well-at-night” portfolio. Our portfolios are user-friendly with income, low turnover, and recognizable companies. We discuss how the dividends provide some downside protection in rough markets and this is probably the strongest differentiator of our approach. But another significant appeal is that dividends do provide consistent income which still remains one of the primary objectives of many individual investors, particularly retirees and pre-retirees. Additionally, for clients who are in the “decumulation” phase, a benefit of rising income is that it enables spending today with the potential for higher spending in the future.
While advisors understand the quantitative benefits of our strategy, the end client may not understand the significance of the low beta, the above-average risk adjusted returns, and the positive alpha that we create. But intuitively, I think clients understand the common-sense, understandable approach to investing in what we do by focusing on quality and dividends. Sometimes simplicity can be more impactful and lead to clarity and focus, not to mention staying with a strategy.
Reception of our philosophy and process from our clients has been strong, resulting in a 98% retention rate. That makes the risk of abandonment very low — and by staying invested, they can fully benefit from the compounding that the capital markets have to offer.
This article was originally published here and is republished on Wealthtender with permission.
About the Author
Bill Hortz
Founder Institute for Innovation Development
To make Wealthtender free for readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a conflict of interest when we favor their promotion over others. Read our editorial policy and terms of service to learn more. Wealthtender is not a client of these financial services providers.
➡️ Find a Local Advisor | 🎯 Find a Specialist Advisor