Quality Investing:The Quality Value Strategy

Our Quality Value investment strategy

In the previous stages, we saw how to apply a stock-market cash-flow strategy and concluded that journey with bonds. We are now entering a new stage focused on long-term capital growth.

The objective changes: instead of primarily seeking periodic income, we are looking to invest in companies capable of increasing their value over time.

To do this, Scale & Own follows a Quality Value strategy, which combines the search for high-quality companies with clear discipline over the price we are prepared to pay for them.

Why do we prioritise US companies?

Although high-quality companies exist all over the world, Scale & Own focuses its analysis mainly on companies listed in the United States, as we have already done in other stages of the investment journey.

The reason is primarily practical: the US market brings together a large number of companies from different sectors and offers particularly broad, frequent and transparent access to the financial information we need to analyse them, with quarterly results and highly standardised published reports.

In addition, many of these companies are global businesses. Companies such as Microsoft, Apple, Alphabet and Coca-Cola are listed in the United States, but generate a significant share of their revenue in different countries and regions around the world.

This does not mean that we rule out opportunities in other markets. We simply use the United States as our principal investment universe.

What are quality stocks?

When we talk about quality stocks, we mean companies that combine three fundamental characteristics:

1. Sustainable growth

Their revenue, earnings and cash flow increase consistently over time, without relying solely on exceptional periods or artificial growth.

2. Solid profitability

These companies are capable of generating profits consistently and converting a significant share of their revenue into cash. They also use that capital efficiently to reinvest in the business, continue growing and create value for shareholders.

3. Good financial health

They maintain reasonable debt levels and have the strength needed to withstand difficult economic periods without endangering the stability of the business.

The distinction from so-called “pure growth” stocks is important. We are not simply looking for companies that promise rapid growth or are fashionable in the market. We are looking for businesses that have already demonstrated, over a period of years, their ability to grow profitably and consistently while maintaining solid fundamentals and healthy cash generation.

But business quality is only one part of our Quality Value strategy. Even an excellent company can become a poor investment if too high a price is paid for it. That is why, in addition to analysing the company, we also pay attention to its valuation.

How do you analyse a high-quality company?

Once we have defined what we are looking for in a high-quality company, the next step is to verify whether it genuinely meets those principles.

To do this, we follow the same fundamental-analysis approach used at Scale & Own: we first study the company’s financial data through quantitative analysis, then examine the aspects of the business that the numbers alone cannot explain through qualitative analysis.

We start with the numbers. If you have followed our previous investment modules, some of these concepts will already be familiar. If not, we will briefly review the necessary definitions as we go.

Quantitative analysis: the Scale & Own filters

To assess a company’s quality objectively, we use a series of filters related to its growth, profitability, cash generation and financial strength.

These criteria are not absolute rules, and a company does not necessarily have to meet every one perfectly. We use them as benchmarks to identify businesses that, ideally, have displayed these characteristics consistently over the past five years.

In addition to the average for the period, we look at the year-by-year progression and prefer a relatively continuous growth trajectory to results that are highly cyclical or dependent on one or two exceptional years.

Sustained growth

We look for companies capable of maintaining solid growth over several years:

• Average annual revenue growth above 10% over the past five years.
• Average annual Free Cash Flow (FCF) growth above 10% over the past five years.

Free Cash Flow is the cash a company generates after covering the expenses required to operate and the investments needed to maintain and develop its activities. It is the cash that remains available to reinvest in the business, reduce debt, repurchase shares or pay dividends.

Return on capital

Growth alone is not enough. We also look for companies capable of using the capital they need to achieve that growth efficiently:

• Average ROIC (Return on Invested Capital) above 15% over the past five years.

ROIC measures the return a company generates on the capital invested in its operating activities. It allows us to assess how efficiently the company uses that capital to produce results. Put simply, the higher the ROIC, the more return the company earns for every dollar of capital it needs to operate and grow.

Financial strength

A high-quality company must also be capable of financing its growth without depending excessively on debt:

• Net debt / Free Cash Flow below 3.

In simplified terms, net debt is the company’s total financial debt minus the cash and cash equivalents available on its balance sheet. By comparing it with the Free Cash Flow generated by the business, we can assess whether that level of debt appears reasonable in relation to its capacity to generate cash.

Capital-management discipline

We also look at how the company’s share count changes:

• A stable or declining number of shares outstanding over the past five years.

When a company continually issues new shares, each shareholder comes to represent a smaller share of the business. This is what we call dilution.

Repurchases can also benefit shareholders by reducing the number of shares outstanding, provided that they are carried out at an appropriate valuation.

Free Cash Flow margin

Finally, we are interested not only in whether Free Cash Flow grows. We also want to know what proportion of revenue ultimately becomes free cash:

• Average Free Cash Flow margin above 10% over the past five years.

The FCF margin indicates what percentage of a company’s revenue becomes Free Cash Flow after expenses and capital expenditure have been covered. Its calculation is straightforward:

100

For example, if a company generates USD 100 in revenue and obtains USD 12 in Free Cash Flow, its FCF margin is 12%.

CAPEX (Capital Expenditures) represents the investments a company makes to purchase, maintain or improve the assets needed to carry out its activities, such as machinery, facilities or technology. These investments consume cash and vary by industry. Two companies with similar earnings can therefore end up generating very different amounts of Free Cash Flow.

Why do we use Free Cash Flow rather than accounting profit alone?

Accounting profit is a useful metric, but it can be affected by depreciation, amortisation, provisions and other accounting adjustments, and does not directly reflect the investments needed to maintain and develop the business.

Free Cash Flow incorporates those investments and shows how much cash genuinely remains available. That is why we use it as one of our main benchmarks.

Qualitative analysis: understanding what lies behind the numbers

A solid history of growth, profitability and cash generation already tells us a great deal about a company’s quality. If a business has maintained good results for years, it is a sign that its model has worked and has demonstrated some ability to adapt and endure in different environments.

However, historical data shows us what has happened, not what will happen. Qualitative analysis therefore focuses on understanding what lies behind those results and identifying changes or risks that could affect the business in the future.

To do this, we ask a number of fundamental questions:

Business model

Do we understand how the company makes money and what drives its growth?

We need to understand what it sells, who its customers are and where its growth comes from. This helps us determine whether that growth is built on solid foundations and can continue.

Competitive advantage

Does it have a sustainable competitive advantage?

A strong brand, network effects, switching costs, economies of scale, intellectual property or pricing power can explain why a company manages to maintain high profitability compared with its competitors. What matters is understanding whether those advantages can endure and what might weaken them.

Industry

Is its industry or competitive position changing?

Technological, regulatory or competitive changes can transform a business that had previously been working well. Here, we need to distinguish between temporary difficulties and structural changes capable of affecting its long-term growth.

Management

Does management allocate capital well, and are its interests aligned with those of shareholders?

We analyse how the company uses the cash it generates: reinvestment, acquisitions, debt reduction, repurchases or dividends. We also pay attention to management incentives and whether its decisions support long-term value creation.

Risks

Are there risks that the numbers do not yet reflect?

Dependence on a small number of customers or suppliers, concentration in one product, new competitors or other company-specific risks can change its prospects before their effects are clearly visible in the financial statements.

Qualitative analysis must be adapted to the company’s industry, business model and specific risks. No universal ratio can replace an understanding of the operational reality of the business.

How can you tell whether a stock is expensive or cheap?

Once we have analysed the company’s quality, we arrive at the second part of our Quality Value strategy: determining whether its valuation is attractive.

To do this, we use different benchmarks that help us understand how much we are paying and what price would make sense.

What is P/FCF and how do you interpret it?

P/FCF (Price to Free Cash Flow) relates a stock’s price to the Free Cash Flow generated per share.

For example, if a stock trades at USD 100 and generates USD 5 of FCF per share, its P/FCF is 20. This means that we are paying 20 times its Free Cash Flow per share.

But a P/FCF of 20 is not expensive or cheap in itself. We need to compare it with similar companies in the same sector and consider factors such as growth, profitability, competitive advantages and risk level.

In general, a company with better prospects, stronger competitive advantages and lower risk may justify a higher valuation. By contrast, a business facing more uncertainty or with a weaker competitive position will generally trade at lower multiples.

We are therefore not simply looking for the lowest P/FCF. We are trying to determine whether the valuation is justified by the company’s quality, risk and prospects.

Why compare the current valuation with its historical valuation?

We can also compare current multiples with those at which the company itself has historically traded.

If a company usually trades at around 25 times its FCF and is currently trading at 18 times, the important question is not simply whether it is cheaper, but why the market is willing to pay less than before.

This is where qualitative analysis becomes fully relevant. A lower valuation may be justified by deteriorating business prospects, the emergence of new competitors or a structural change in the sector. But the market can also overreact to bad news or to a temporary problem whose actual consequences are less significant than the decline suggests.

Why use the P/E ratio as well?

P/FCF is one of our main benchmarks, but we can supplement it with the P/E ratio (Price / Earnings) to obtain another perspective on valuation.

This is particularly useful when Free Cash Flow is temporarily reduced by substantial capital investment. For example, some large technology companies may temporarily increase their CAPEX to build data centres or develop new infrastructure. In these cases, comparing the change in the P/E ratio helps to verify whether underlying profitability remains intact despite the temporary decline in free cash.

How do you recognise a value trap in the stock market?

Finding a high-quality company trading below its historical valuation may look like an opportunity. But a low valuation does not necessarily mean that a stock is cheap.

In some cases, the market is simply reflecting a deterioration in the prospects of the business. When a company looks cheap because its fundamentals are deteriorating structurally, we may be looking at a value trap.

A temporary problem or structural deterioration?

This is one of the most important questions when a high-quality company starts trading at a significant discount.

A company may experience temporary difficulties, such as disappointing quarterly results, a one-off decline in demand or a cyclical increase in costs, without its long-term prospects necessarily changing. One representative case was:

Meta in 2022, when the stock fell sharply amid concerns about spending on the metaverse and the slowdown in the advertising market, while its core business continued to generate substantial cash flows.

The situation is different when the problem is structural: the loss of a competitive advantage, technological changes, new competitors or transformations that permanently reduce the business’s ability to create value.

Nokia is a classic example: after the rise of smartphones, its historical multiples could make the stock look cheap, but the company had lost much of its competitive position in the new market environment.

How do you distinguish an opportunity from a value trap?

Before deciding that the discount represents an opportunity, we return to our investment thesis and check:

• Does the problem mainly affect the short term, or does it alter the long-term prospects of the business?
• Does the company retain the competitive advantages that explained its quality?
• Are its growth, profitability and cash generation still sustainable?
• Are the valuation benchmarks we use still valid in light of the new information available?

This last point is particularly important. We must not compare the current price with a valuation based on a reality that no longer exists. If the fundamentals or prospects of the business have changed, we need to incorporate that new information into our analysis.

The key idea

A decline may offer us the discount we are looking for, but it will only be an opportunity if the price has fallen more than the value of the business.

Margin of safety and patience

Once we have established that the discount is not the result of structural deterioration in the business, we still need to decide whether the price offers a sufficient margin to compensate for the uncertainty in our analysis.

This margin of safety means buying at a sufficient discount to the valuation we consider justified. The greater the uncertainty surrounding the business, its prospects or our valuation, the greater the margin we should require.

There is no percentage that is appropriate for every company. A highly predictable company with solid competitive advantages and consistent results may justify a smaller margin than a more cyclical business or one exposed to greater risks.

And if an excellent company does not yet offer a sufficiently attractive valuation, we do not have to buy it. Patience is part of our Quality Value strategy: we would rather wait for a better opportunity than lower our criteria simply to be invested.

Where does a stock’s long-term return come from?

Now that we have a more complete view of how to analyse a company’s quality and valuation, we can bring together what we have learned around one simple idea: where does a stock’s long-term return actually come from?

In simplified terms, we can divide it into three principal drivers.

Driver 1: growth in FCF per share

The main long-term driver is growth in Free Cash Flow per share. If a company manages to generate increasingly more cash per share and its valuation multiple remains reasonably stable, its share price will tend to follow the growth of the business.

The compounding effect can be considerable:

• Annual growth of 10% multiplies FCF per share by approximately 2.6 over ten years.
• Annual growth of 15% multiplies it by approximately 4 over the same period.

This is why we place so much importance on sustainable FCF growth in our quality criteria.

Driver 2: change in the P/FCF multiple

The second driver comes from changes in valuation.

If we buy a company at a P/FCF of 15 and, several years later, it trades at 20 times its FCF, that multiple expansion will add to the return obtained from the growth of the business.

But the opposite can also happen. If we buy at too high a valuation and the multiple subsequently declines, that contraction can offset part of the company’s growth.

What effect can a change in P/FCF have?

We can measure the annualised effect of a change in the multiple using CAGR (compound annual growth rate):

P/FCF at purchase	Final P/FCF	Annual effect over 10 years	Annual effect over 20 years
10	20	+7.18%	+3.53%
10	30	+11.61%	+5.65%
15	25	+5.24%	+2.59%
20	30	+4.14%	+2.05%
30	20	−3.97%	−2.00%
30	10	−10.40%	−5.34%

This table shows an important lesson: the longer our investment horizon, the greater the weight of business growth and the smaller the annual effect of a one-off change in the multiple.

Our thesis should therefore not depend on the market paying ever more for the company. We want value creation to come primarily from business growth and an attractive valuation at the time of purchase to provide us with a favourable starting point.

Driver 3: dividends

Dividends are the third driver. Although they are not the principal objective of our Quality Value strategy, they add to the return obtained from business growth and changes in its valuation.

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Your next step at Scale & Own

Throughout this stage, you have learned how to apply a Quality Value strategy: identify companies that have demonstrated growth, profitability and financial strength, understand the business behind their results and assess whether their valuation offers an attractive opportunity.

You have also seen that a good company is not always a good investment: the purchase price matters, and an apparent opportunity can become a value trap if the decline reflects genuine deterioration in the business. With this method, you have a solid foundation for analysing individual stocks using your own judgement.

In the next module, we will continue our journey by exploring ETFs and passive investing, to analyse how these instruments work and the situations in which they can complement or simplify a long-term investment strategy.

Continue with the next step: ETFs and passive investing

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06 · Bonds

• The Scale & Own strategy
• Why US companies
• What quality stocks are
• How to analyse a company
• Stocks: expensive or cheap?
• The value trap
• Where returns come from
• Your next step

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