Identifying quality

Identifying high quality businesses is undoubtedly the key aspect of my investing strategy. If I get this right then I will benefit from the magic of compounded growth over time from businesses that are in general likely to be undervalued. In an ideal world I should be buying the kind of shares that I can ‘buy and hold’ forever.

This post is an attempt to bring a bit more structure and clarity to how to assess quality and to unpack some parts of it in a bit more detail.

Quality is a broad concept and hard to define or measure. The underlying objective in assessing quality should be to predict a business’s discounted and risk adjusted future cash return on investment. Luckily I don’t need to do this in an absolute sense but can more simply identify which businesses are higher quality than others. I can approach this with the easier question ‘does the business possess characteristics which make it more likely than other businesses to be able to compound its profits over the long term to a greater extent?’

I am looking for businesses that earn a lot of profit that turns to cash (i.e. it do not need to invest a lot of money on physical assets to continue operating), are able to reinvest this profit to grow at a high rate of return and are able to repeat this process consistently and sustainably far into the future.

There’s a number of relevant factors needed to make this assessment. To give it a bit of structure broadly I look at the following:

  1. Does the business have ‘good economics’?  Does it have little debt? Does it convert profits into cash? Does it have a high return on capital?
  2. Does the business have a good track record? Consistent and stable growth in profits and cash over time; steadily growing share price over the long term.
  3. What does the business do? How (uniquely) valuable will this be to its customers in the future?
  4. Does it have a competitive advantage or ‘moat’ that allows it to persistently earn high margins? Is it increasing its market share?
  5. What scope is there for more growth? Is it in a growing market? Is it non-cyclical? What is the prospect for geographic expansion?

The order of these questions might seem a bit strange – why only get to what the business does at point 3 rather than earlier? This is an issue of practicality: points 1-2 can be assessed quantitatively while 3-5 need to be assessed qualitatively. Quantitative screens can greatly facilitate the process of scouring the stock market for candidates so it is practical to ask these questions first.

Does the business have ‘good economics’?

The key measure of a business’s quality is its long run return on capital. While not predictable in advance in the long run this is the key fundamental determinant of the return from investing in a stock. At a high level the idea is very basic, ROCE tells how profitable a company’s assets are or to put it another way what return it achieves for investing in these assets.

While we can only measure historic ROCE, we are actually interested in the incremental ROCE the business will make on future investments e.g. how much profits will increase if it invests in developing a new product. Obviously this can’t be measured directly but you can look at the incremental ROCE from historic investments or more simply at average ROCE over an extended time period to get an idea of this in the past. A high quality business with an enduring advantage should have a stable and high historic ROCE – in my view this is a necessary but not sufficient condition. I will typically screen for 5yr average ROCE above 20%.

Another important aspect of business economics to consider is free cash flow conversion i.e. the extent to which profits are converted to cash rather than being swallowed up by new investments. This links to ROCE – a business with a high return on capital should as a consequence also either turn a high proportion of its profits into cash or in some cases, where it is able to profitably reinvest a high proportion of cash, be growing at a tremendous rate. I will typically look at cash flow over the last few years to get a sense of cash conversion, whether there are any anomalies and a picture of how much the firm has been investing recently.

A final quantitative check I use in screening is the net debt level. A high quality business of the sort I want to invest in should generate a lot of cash and will generally not have much debt or will have net cash. I don’t invest in any business with high net debt – partly because it creates risks of liquidity or insolvency, but mostly because it indicates that it is not the sort of business I’d want to invest in (high capital requirements or poor cash generation). I might make exception for larger businesses who may sometimes ‘leverage up’ if they have a lot of profitable opportunities to invest in, but I do this rarely and carefully.

Does it have a good track record?

I am looking for businesses with consistent, sustainable growth in the future and I believe one good indicator of this is whether this has occurred in the past.

To this end, as well as looking at ROCE I screen for 5yr CAGR in profit, FCF and look at the consistency in growth over time. I also more simply look at the long term share price chart (or screen for the long term relative price strength). A high quality share in my view should always have a steadily increasing share price over the longer term (e.g. 5-10 years) – if I see any major bumps on the way I’m interested to understand what happened. While it can sometimes happen, I do not think it is that common for previously ordinary businesses with oscillating performance and share price to suddenly then become great businesses.

What does the business do?

No doubt if you’re reading this you’ll have heard a thousand times that you should be sure to understand what a business does before investing in it. I don’t think this is an absolute necessity for investing in general but for my approach it is. It is impossible to understand a business’s competitive position and the long term prospects of the market without understanding what it does.

In my view the point is to understand is the customers’ perspective. Why do they need the product / service and how certain is it that they will still need this in 10 years time, or 20 years time? This thought experiment can tell you quite a bit – I screen out a lot of shares simply on learning what the business does either because I am not comfortable I understand it well enough or because I am not sufficiently confident that the business or its market will endure into the future.

The ‘moat’

An enduring competitive advantage is a large part of the inherent reason why high quality shares can generate very high rates of return for extended periods of time.

Competitive advantages can come from a variety of sources. A thought experiment you can employ to look at whether a firm has a competitive advantage is to consider what it is that is constraining the business from raising its price. These constraints can either come from the demand side i.e. from customers switching to alternative products, or from the supply side i.e. from competitors entering the market with new products. A competitive advantage will come from features that reduce the effect of these constraints.

I have quite a bit of experience in analysing competitive advantages from my day job as a competition economist. However, this is only helpful to some extent. Looking into the future is more art than science but at least I have an idea of what to look for. Hopefully over time I can develop a more systematic way at looking at this but for now here are some of my thoughts on the common sources of competitive advantage.

Intellectual property is a common source of competitive advantage. There are many different types of IP including patent, brands, know how and data. Even if IP is not legally protected, there may be an advantage from the know-how, data and reputation that comes with being the first to develop a product or service that competitors may find difficult to replicate – a first mover advantage. Many of the businesses I invest in will have some sort of IP – to assess the competitive advantage it conveys what matters is how well difficult it is to imitate.

Brands are quite self explanatory and my thoughts on them are relatively straightforward. Stronger brands have fewer similar rivals, signal high quality rather than low price, are able to charge higher prices than their competitors without losing market share and typically have been around for longer. As an example, I believe Fevertree currently in my portfolio is a very strong brand as it has found a good niche with few rivals (premium mixer) and has been growing very strongly while charging a big premium for its product. Brands of ‘value’ products e.g. Boohoo in my portfolio, can also be good though I think are inherently weaker and more susceptible to competition as their low price point is a core part of the proposition.

Another source of competitive advantage for services with repeat business can come from features which prevent customers switching and ‘lock them in’ to continue to buy the product from the same supplier regardless of the price. I’ve found this is often a useful feature of IT businesses (like Micro Focus or Craneware) whose customers treat its products as indispensable as they would find it prohibitively difficult or expensive to switch. With existing customers effectively locked in the business can then afford to focus on growth to a greater extent. Similar to features that make switching difficult, strong client relationships and customer specific distribution networks can also make it unattractive for customers to switch away.

Network effects occur when the value one customer gets from a service depends on the number of other users. This gives huge advantages to first movers and to scale. Network effects are an increasingly common feature occurring in internet based markets (think Google and Facebook). Platforms can exploit network effects to become a ‘gatekeeper’ to a market (think Rightmove). As a source of competitive advantage they are incredibly powerful and competition between platforms often results in ‘winner takes all’ unless users find it practical and easy to ‘multi-home’ (use more than one platform). As a result I think they can make great investments though the flip side is that risks can be high – holding anyone other than the dominant player can turn out disasterously and while network effects provide protection from competition, higher tech internet based businesses are often subject to wholesale disruption from entirely new distribution channels or business models. I have some of these in my crosshairs waiting for a good opportunity to buy.

On the supply side, the most straightforward competitive advantage is the cost advantage, particularly coming from scale. This can be more relevant in more capital intensive markets in which I tend to be less interested. Cranswick and Hilton Foods are exceptions where I believe these businesses have been able to exploit cost advantages in defensive industries to consistently generate decent returns on capital.

Identifying the existence of a moat is generally quite easy. Often it is intuitively obvious and even when it is not businesses will be very happy to explain what it is in their reports and presentations.

Assessing the strength and sustainability of a moat can be much more difficult. It is often a case of qualitative judgment e.g. ‘how strong a brand is this?’ but there are also some useful indicators. Market share is one – as a competition economist this has a specific meaning to me but the broad idea is that a competitive advantage should imply few competitors or competitors with fewer sales. Perhaps more important than the market share itself is whether it is growing. Businesses that are rapidly taking sales from their competitors naturally can make great investments – this is something I look out for. Sustainable high margins are another indicator of competitive strength. This can be captured in screening though what you should consider as ‘high’ may vary from industry to industry to some extent.

Growth potential

To make a good investment a business must continue to have opportunities to invest its capital in. Growth opportunities can arise from secular growth of the whole market the business operates in, increasing market share within that market or adding new products, services or geographies.

Of these I think secular long term growth of the whole market is the most important. It is more likely that you can be confident this growth potential will persist in the long term. You can be pretty confident that markets of many consumer products as well as markets which benefit from ageing demographic trends (e.g. healthcare and funerals) will continue to grow over time. Particularly as businesses with a proven competitive advantage will tend to already have a high market share there are limits to growth through increasing market share. Geographic expansion can generate rapid growth though comes with risks. Adding new products is riskier still. When assessing growth potential I think the key is not to get too carried away in thinking about the potential scale of growth but to focus more on its certainty and sustainability. One thing this implies is avoiding businesses in cyclical markets (and particularly those with high capital requirements).

It’s also important to think about risks. The tendency is for most markets to continue to grow slowly (and newer markets more rapidly) over time, though some will succumb to changing preferences or technological change and fall by the wayside. The key risk to returns comes from increased competition, hence the importance of the moat. The other big risks in my view are technological and regulatory. Technological change or regulatory intervention are common threats and have the potential to have a drastic effect on profits. Its worth thinking about these risks before investing and steering investments towards those markets where they are less likely to be present.

Management

Frankly I think it’s a bit of a waste of time to think much about the quality of management. It’s not so much that I don’t think management is important, it’s just that I don’t see a sensible way for me to reliably assess management quality. A business with a good track record and a competitive edge may often imply good management, though in my view it makes a lot more sense to look directly at this rather than at the management quality itself.

An exception to this is that I think it can be a good sign if a business is managed by a founder with skin in the game. I believe there is some evidence that founder-managed businesses do better than average. I think this might be because these types are likely to know their business better and have more ‘grit’ to get going when the going gets tough.

Overall, I think from my perspective assessments of management quality pale into insignificance relative to the other points mentioned and is more likely to muddy the water when coming to an overall decision than improve it. In general I’m minded to ignore it.

Weighing it all up

Having looked at all these factors how to weigh it all up together and decide whether a share is of sufficient quality to put on my shortlist? This part of the process is difficult. Even with great underlying analysis I think it’s all too easy in the to put too much weight on the wrong things in coming to a decision, rendering the analysis useless.

A starting point is to note that I’m setting the bar quite high. I definitely don’t want more than 100 high quality shares in my ‘investing universe’ (portfolio and shortlist) and probably nearer 50 is better. At the moment there are 65 which feels about right. Maintaining the shortlist is a fluid process – I am frequently dropping or adding candidates as my assessment of their quality becomes more informed and detailed over time. I believe the list should become more settled in time though. I always assess quality in more detail before deciding to add a share to my portfolio.

I’ve tried to make the decision to add a share to the shortlist easier by putting the different factors in the quality assessment into a simple but coherent analytical structure. All points in this structure are important and need to be met at least satisfactorily for a share to get on the shortlist – it needs to be a business with good economics, a good track record, a competitive advantage and decent growth prospects. Using this simple structure when making the overall decision should reduce the risk of me getting biased by irrelevant details.

A final point I’d make about the overall assessment is to make sure my perspective is sufficiently long term. The point is to restrict my investing universe to the highest quality shares – there lies value. Shorter term factors may help guide what actually goes in my portfolio and when but shouldn’t influence what gets into the shortlist in the first place.

 

 

 

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