Methodology

One sign of quality companies’ endurance is that our screen produces many of the same names year after year. As with any stock screen, this serves to underline that a quantitative process still requires some qualitative assessment once the data has been presented – be that choosing between companies, or acknowledging what the data doesn’t show. On the former point, this year we have chosen four companies not found in previous years’ selections, ignoring those that rank slightly higher on the 2023 screen but which have already featured in either our 2022 or 2021 analyses.

The screen itself, based on our UK High Quality Large Caps screen, insists on a few important characteristics: positive free cash flow, forecast earnings growth, a history of margin expansion, improving returns on equity and manageable interest payments. The tests are as follows:

■ Return on equity (RoE) in the top quarter of all stocks screened in each of the past three years.

■ Operating margin in the top quarter of all stocks screened in each of the past three years.

■ Earnings growth forecast for each of the next two years.

■ Interest cover of five times or more.

■ Positive free cash flow.

■ RoE growth over the past three years, or an RoE of at least 35 per cent.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

■ NTM PE between 40th and 90th percentiles.

As ever, we must note what isn’t covered. The screen is particularly focused on high margins, which naturally tends to exclude those firms that generate large profits on high volumes yet with low-margin returns. Some companies’ high spending on long-lasting intangible assets such as brand awareness or intellectual property can depress their reported profits and margins, given this spending is often treated as day-to-day costs. That makes it less likely that they will be captured by the screen’s metrics.

The final point of note has to do with price. Our screen is relatively price agnostic: not unreasonably, investors have tended to be willing to pay up for shares that can compound returns over the long term. The events of 2022 in particular showed that there is a flipside to this: in times of market stress, share prices can drop even when a company’s underlying operations (and the hallmarks of a quality business, such as its margins and cash flow) remain resilient. Twelve months on, and there is no denying that many quality US companies are again trading on pretty elevated valuations. But the attractions of many of these companies are strong enough to help offset some of these concerns over the long term.