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Should you look to add Alphabet to your portfolio after earnings disappointment?

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The 62% revenue growth reported this time last year at Alphabet (NSQ:GOOGL) was always going to be tough to match - in the first half of 2021, companies were on an advertising spending spree as they sought to shore up sales post-pandemic. But still, revenues up just 13% owing to a bog slow down in the dominant advertising division of the business was a disappointment. Ads revenues in both Google Search and YouTube were lower than expected.

But investors sent Alphabet's stock up in extended trading following the announcement. That may be because companies with the financial firepower to resist economic turmoil are always high on investor shopping lists, even if they might have to endure the occasional blip.

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Why top investors target quality

Elite money managers often point to company quality as a defining factor in long-term investing success. Terry Smith, the highly respected founder of Fundsmith, has said that all the clues to a good business can be found in its numbers. He cemented his formidable reputation on the basis of buying good companies, not overpaying for them and then doing nothing.

But for regular investors, what does that strategy really involve?

The answer is that quality can show up in all sorts of ways in different companies. Helpfully, there are some universal signs to look for. Truly resilient firms often have defensible competitive advantages in their markets. That means they can generate consistently high levels of profitability - no matter what the economy throws at them.

Well-defended profitability not only gives them a financial safety net, but also the flexibility to allocate capital effectively. That means deploying time, money, ideas and people to best effect. If they do it well, you’ll see it in the accounts.

Typically, the clues can be found in profitability measures like operating margins and return on capital employed. When these stretch into double-digits over several years, it can be a pointer to a strong, profitable business.

But of course, premium profitability can attract premium valuations, so it’s worth considering valuation and future growth too. A simple rule of thumb here is the price to earnings growth ratio (PEG). This is a guide to whether the valuation is reasonable versus the rate of earnings growth. A PEG of 2 is generally considered expensive, so screening for anything less will restrict the results to more reasonable valuations.

Finding quality in the numbers

With a five-year average operating margin of 23.6%, Alphabet is clearly doing something right. High operating margins are a pointer to firms with products that customers can’t get enough of - and are unlikely to look elsewhere for. This kind of pricing power contributes to the fact that the company’s earnings per share have been growing at a compound rate of 32.1% over the past five years.

With a long-term average ROCE of 17.0%, it’s also clear that Alphabet has been doing a good job of allocating capital and reinvesting to support further growth in its profitability. This shows up in a five-year average Return on Equity of 20.6%. Return on Equity is a measure of how efficiently a company uses shareholders’ equity to generate profits. Companies with consistently high ROEs tend to exhibit the high-quality, competitive business traits that deliver resilient profitability.

Hunting for strong businesses

Overall, Alphabet has some impressive longer-term quality traits that suggest the business is well placed to weather turmoil and continue growing. As Terry Smith insists, when it comes to finding fundamentally good companies, it's worth asking yourself:

  • How has the business achieved being good - and is it sustainable?

  • How does it compete - and it is doing it effectively?

  • Does it show the signs of a business that can allocate capital well?

Companies that score well against this kind of checklist can be well-placed to see their profitability benefit from the compounding effects of competitive strength. And just like Terry Smith, once you’d found one, it can be worth sitting on your hands and holding for the long term.

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