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 more detail.
Quality can be a broad concept and hard to define or measure. That said, I have tried to define it as precisely as I can. According to my definition, quality is determined by the total return a business will make in the future over the long run. Because the future is uncertain, quality is about the certainty, as well as extent of long term profits.
Following this logic, the underlying objective in assessing quality should be to predict a business’s discounted and risk adjusted future cash return on investment. Luckily you don’t need to do this in an absolute sense, but can rather more straightforwardly aim to identify which businesses are higher quality than others: ‘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?’
You are looking for businesses that earn a lot of profit that turns to cash (i.e. 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 are many relevant factors that determine this. To ensure you focus on the most relevant factors and interpret them in the right way I think it is key to apply some analytical structure. I have come up with the following structure (formed into a short checklist) that I can apply systematically to assess possible investments:
- 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?
- Does the business have a good track record? Does it have consistent and stable growth in profits over time and a steadily growing share price over the long term?
- Does it have a competitive advantage or ‘moat’ that allows it to persistently earn high margins?
- What scope is there for more growth? Is it in a growing market? Is it non-cyclical? What prospects are there for increasing market share or for geographic expansion?
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 any equity investment. At a high level the idea is very basic. ROCE tells you how profitable a company’s assets have been, or to put it another way what return the business has achieved 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 to get an idea of this from the past you can look at the incremental ROCE from historic investments or more simply at average ROCE over an extended period. A high quality business with an enduring advantage should have a stable and high historic ROCE. 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 tend to invest in any business with much 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?
One good indicator of whether a business will have consistent and sustainable growth in the future is whether it 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 or service and how certain is it that they will still need it 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.
A sustainable competitive advantage is a large part of the reason why certain high quality businesses can generate very high rates of return for many years. For many businesses high profitability is temporary as it attracts competition.
Competitive advantages can come from a variety of sources. Competition comes from either customers switching to alternative products or competitors entering the market with new products. A competitive advantage is built from characteristics which reduce the possibility of either of these things happening.
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 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 is an example of an exception 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 – 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.
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. There are limits to growth in market share, particularly as businesses with a proven competitive advantage will tend to already have a high 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 customer 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.
Frankly I think it’s a bit of a waste of time to think too 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 and practical way 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 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 judgments of management quality pale into insignificance relative to the other points mentioned. Personal judgments can be very powerful and I worry that they would be more likely to muddy the water than improve decisions. In general I’m minded to ignore them.
Weighing it all up
Having looked at all these factors how do you 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 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 watchlist) and probably nearer 50 is better. At the moment there are 65 which feels about right. Maintaining the watchlist is a fluid process – I am frequently dropping or adding candidates as my assessment of their quality becomes more informed and detailed over time. The list should become more settled in time. 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 watchlist 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 decisions 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 watchlist in the first place.