What Quality Growth Really Means

Long-term, this is not a "quality" way to grow.

So what is a "quality" way to grow?

The best companies fund their growth initiatives through internal cash flows. This is the best of all worlds for investors. They are not diluted, and the balance sheet can remain pristine, which removes a lot of financial risk. If a firm can take its internal cash flows and re-invest them at attractive rates, this sets up a "flywheel" of self-sustaining growth that generally leads to big advances in the stock price, as well.

How do we measure this? The Quality Growth spell is also limited to only stocks with a free cash return on invested capital in the top 20% of the market. At present, the minimum bar for this is about a 21% cash return on capital! That means that all Quality Growth stocks are not only growing revenue rapidly, but have also proven their ability to re-invest their (always positive!) free cash flows at very attractive rates.

Bingo, the "flywheel" of self-sustaining and safer growth we are looking for!

Are There Quality Growth Anomolies?

While the majority of the stocks in the spell fit the "spirit" of the screen very well, there are a few oddities to be aware of.

One notable group are pre-clinical biotechnology stocks that have received a large recent cash milestone payment, usually from a larger and established healthcare firm they are partnered with. Generally, these firms don't earn much in the way of ongoing revenue (their drugs are still in testing phases), but when they pass a milestone like a successful Phase I or II trial, or a study meets a goal endpoint, their partners will pay them a lump sum to continue developing the drug.

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This is problematic for the Quality Growth Spell, because it does two things. One, it boosts their revenue line dramatically and immediately. Even averaging it out over 3 years, these milestone payments often make it look like these small firms grew revenue over 100% or more annually! That is not really the case - this revenue is not a course of regular business, and not sustainable going forward.

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Disclosure: Steve owns no stocks referenced here.

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