“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett (1989)¹

What makes a quality business?

Investing in quality businesses is hardly a new concept. For decades, investors have sought companies capable of generating strong profits, maintaining competitive advantages and performing consistently through changing economic conditions. This philosophy, popularised by investors such as Warren Buffett, has since evolved into a systematic investment style known as the Quality factor.

Academic research has shown that companies with strong profitability have historically delivered attractive investment returns.^2,3 One possible explanation is that investors underestimate the persistence of earnings among fundamentally strong businesses, while overestimating the prospects of companies with less durable profits. However, strong profits alone do not necessarily make a quality business. A company may report impressive earnings today, but are those profits stable or driven by excessive borrowing, aggressive accounting or unusually favourable conditions?

To address this, we assess Quality through two complementary dimensions: how profitable a company is and how reliable those profits are.

The Power of Profitability

The first dimension focuses on profitability, using net profit margin and return on invested capital (ROIC) to assess how effectively a company converts revenue into profits and generates returns on the capital invest, namely debt and equity. Companies that consistently maintain high margins and ROIC may hold an economic moat, with durable competitive advantages such as pricing power, economies of scale or barriers to entry that help protect profitability from competitors. We favour ROIC over the more commonly used return on equity (ROE), which can be distorted by financing decisions. For example, debt-funded share buybacks reduce shareholders' equity and can artificially inflate ROE without improving underlying business performance.⁴ ROIC can therefore provide a clearer picture of how efficiently a company puts its capital to work.

The Staying Power of Earnings

The second dimension considers earnings fragility, recognising that not all profits are equally reliable. This involves evaluating whether earnings are supported by excessive financial leverage, how heavily profits depend on accounting accruals rather than cash generation, and whether a company consistently delivers profits over time. Leverage is particularly important as interest rates move through economic cycles. Businesses with high levels of borrowing may appear financially healthy when interest rates are low, but face increasing pressure as borrowing costs rise, making their earnings more vulnerable during periods of financial stress.

Accounting accruals offer another perspective by examining the relationship between reported earnings and actual cash generation. This distinction matters as a company can report strong profits on paper without generating the cash to match. A well-known example is WorldCom, which wrongly recorded around $3.8 billion of operating costs as long-term investment assets in 2001 and early 2002, making profits appear higher than they really were. The fraud was eventually uncovered, and the company subsequently went bankrupt.⁵

While WorldCom was an extreme case, accrual accounting often involves judgement rather than outright manipulation. For example, technology companies investing heavily in AI infrastructure spread the costs of computing equipment over several years. In 2025, Amazon shortened the estimated useful lives of certain servers from six to five years, citing rapid advances in AI and machine learning. The company estimated that this change would reduce its 2025 operating income by around $700 million.⁶ This illustrates how accounting assumption changes can influence reported future earnings even without any change in the underlying cash spent.

Finally, earnings variability measures how steadily a company generates profits over time. Consider Zoom, which experienced extraordinary demand during the COVID-19 pandemic, when annual net income reached $1.4 billion in fiscal 2022. However, as demand normalised and costs increased, its profits fell sharply to just $104 million the following year.⁷ By November 2022, its share price had already fallen around 90% from its pandemic-era highs, as market expectations adjusted.⁸ Though the situation was unusual, it does show that exceptional profits during favourable conditions do not always reflect what a business can sustain over the longer term.

Overall, these three assessments help distinguish companies with durable earnings from those that are more vulnerable to financial stress or future disappointments. Figure 1 examines how profitability and earnings fragility relate to subsequent return volatility and return per unit of risk. Companies are grouped by their profitability and earnings fragility relative to others in the same sector. We then compare how their returns typically fluctuate over the following three months and the returns they generate relative to that risk.

The results reveal a clear pattern. More profitable companies generally experience lower return volatility, but the reliability of those earnings provides an additional layer of protection. Even among the most profitable companies, those with robust earnings experience lower volatility (27.3%) than their more fragile counterparts (30.8%), while also delivering higher returns per unit of risk (0.29 versus 0.24). The contrast becomes even more striking when comparing the two extremes, with highly profitable companies exhibiting robust earnings delivering more than twice the return per unit of risk (0.29) compared with less profitable, fragile businesses (0.14). In other words, while strong profitability is associated with lower investment risk, earnings fragility matters too. Two equally profitable companies can experience meaningfully different levels of volatility depending on how reliable their earnings are. For long-term investors, this distinction matters as volatility, particularly when accompanied with large losses, can disrupt the compounding effect and leave less capital to benefit from future returns.

Quality as a measure of resilience

Ultimately, investing in Quality is not simply about identifying companies with the highest profits, but understanding how durable and repeatable those profits are. By combining profitability with earnings fragility, investors can look beyond headline earnings to identify businesses with stronger financial characteristics. The aim is to differentiate companies whose profitability is built to endure from those more exposed to financial distress, earnings disappointments and downside risk.

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References

1.    Buffett, W.E. (1989). Chairman's Letter – 1989. Berkshire Hathaway. Available at: Berkshire Hathaway shareholder letters (Accessed: 16 October 2026).

2.    Novy-Marx, R. (2013). 'The other side of value: The gross profitability premium', Journal of Financial Economics, 108(1), pp. 1–28. Available at: https://doi.org/10.1016/j.jfineco.2013.01.003.

3.    Asness, C.S., Frazzini, A. and Pedersen, L.H. (2019). 'Quality minus junk', Review of Accounting Studies, 24(1), pp. 34–112. Available at: https://doi.org/10.1007/s11142-018-9470-2.

4.    Aramonte, S. (2020). 'Mind the buybacks, beware of the leverage', BIS Quarterly Review, September. Available at: Bank for International Settlements (Accessed: 16 October 2026).

5.    WorldCom Special Investigative Committee (2003). Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc., 31 March. Available at: SEC-hosted investigation report (Accessed: 16 October 2026).

6.    Amazon.com, Inc. (2025). Annual Report 2024 (Form 10-K). Available at: Amazon SEC filing (Accessed: 16 October 2026). See page 41.

7.    Zoom Video Communications, Inc. (2023). Annual Report 2023 (Form 10-K). Available at: Zoom SEC filing (Accessed: 16 October 2026).

8.    Soni, A. and Mehta, C. (2022). 'Zoom shares down 90% from peak as pandemic boom fades', Reuters, 22 November. Available at: Reuters article (Accessed: 16 October 2026).

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Important Information 

This document is issued by Osmosis Investment Management UK Limited (“Osmosis UK”). Osmosis UK is an affiliate of Osmosis Investment Management US LLC (“Osmosis US”), Osmosis Investment Management NL B.V. (“Osmosis NL”) and Osmosis Investment Management AUS Pty Ltd (“Osmosis AUS”), and has been operating the Osmosis Model of Resource Efficiency. Osmosis UK is regulated by the FCA (Reference number: 765056). Osmosis US is regulated by the SEC. Osmosis NL is licensed as a manager of AIFs and authorised to provide discretionary portfolio management services and as such is subject to supervision by the Netherlands Authority for the Financial Markets under registration number 15006165.Osmosis UK, Osmosis US, and Osmosis AUS are wholly owned subsidiaries of Osmosis (Holdings) Limited (“OHL”).  

This research provided is for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities. No representations, express or implied, are made as to the accuracy or completeness of such statements, assumptions, estimates or projections or with respect to any other materials herein. 

The investment examples set forth in this presentation should not be considered a recommendation to buy or sell any specific securities. There can be no assurance that such investments will remain in the strategy.  The case studies have been selected to be included in this presentation because we believe these are indicative of our strategy and investment process. Nothing herein shall be deemed to limit the investment strategies or investment opportunities to be pursued by Osmosis.  

The information contained in this document has been obtained by Osmosis from sources it believes to be reliable, but which have not been independently verified. Information contained in this document may comprise an internal analysis performed by Osmosis and be based on the subjective views of, and various assumptions made by, Osmosis at the date of this document. Osmosis does not warrant the relevance or correctness of the views expressed by it or its assumptions. Except in the case of fraudulent misrepresentation or as otherwise provided by applicable law, neither Osmosis nor any of its officers, employments or agents shall be liable to any person for any direct, indirect, or consequential loss arising from the use of this document.