What does investment grade attributes mean
As briefly discussed in the previous chapter, investment-grade companies have a number of distinctive characteristics. These characteristics can be divided into two categories: qualitative and quantitative aspects. The process of evaluating fundamentally strong companies involves examining these two aspects. In fact, in my personal investment practice, I pay a little more attention to the qualitative aspects than to the quantitative ones.
The Qualitative aspect is primarily an understanding of the non-numerical aspects of the business. This includes a number of factors such as:
- Management’s history– Who is part of the management team, their background, experience and education, their merits in running the business and the criminal cases against them
- Business ethics – Whether management has been involved in fraud, bribery or unfair and unethical business practices
- Corporate governance – Appointment of directors, organization structure, transparency etc.
- Minority shareholders – How management treats minority shareholders, and whether the company acts in their interests while taking corporate actions
- Share transactions – Does management buy and sell stocks of the company through a secret group pf promoters?
- Related party transactions – are financial services provided to known individuals, such as relatives, friends and suppliers of promoters, at the expense of shareholders?
- Salaries paid to promoters – Does the company's management pay itself a large salary (usually a percentage of profits)?
- Operator activity in stocks – Does the stock price show abnormal price movements, especially at a time when the promoter trades stocks?
- Shareholders – Who are the major shareholders in the firm or own more than 1% of the outstanding shares of the company?
- Political affiliation – Does the company and its promoters have any political affiliation? Is the business in constant need of political support?
- Promoter lifestyle – Is the promoters’ lifestyle too extravagant and flashy? Do they like to display their wealth?
Red flags appear when any of the above elements do not fall into the right places. For instance, if a company does business with too many related parties, it signals favoritism or fraud on the part of the company. This is not good in the long run. So even if the company generates high profit margins, fraud is not acceptable. It will only be a matter of time before the market discovers issues related to "related party transactions" and punishes the company by lowering the stock price. A low corporate governance score means that it is better not to invest in companies with high rates of return.
The qualitative aspects are not easy to uncover because they are very sensitive issues. However, the diligent investor can easily see this by paying attention to annual reports, management interviews, and news reports.
Quantitative aspects are aspects related to financial performance. Some quantitative aspects are easy to understand and others are not. For example, cash held as inventory is simple, but "days in inventory" is not. This metric requires calculation. The stock market pays a lot of attention to quantitative aspects.
There are various quantitative aspects, but we will list only some of them.
- Profitability and its growth
- Margins and its growth
- Earnings and its growth
- Matters related to expenses
- Operating efficiency
- Pricing power
- Matters related to taxes
- Dividends payout
- Cash flow from various activities
- Debt – both short term and long term
- Working capital management
- Financial Ratios
The list is virtually endless. As a matter of fact, there are different metrics for individual sectors. For example:
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For a Retail industry
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For an Oil and Gas Industry
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- Total number of stores
- Average sales per store
- Total sales per square foot
- Merchandise margins
- Owned store to franchisee ratio
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- Oil to Natural Gas revenue ratio
- Exploration costs
- Opening oil balance (inventory)
- Total production growth
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