I’ve wondered which shares I would hold if I was only invested in the FTSE 100. Very large businesses tend to be somewhat more durable and less volatile. If I was someone that didn’t want to spend a lot of time and effort monitoring a set of smaller cap stocks I might stick to investing in a basket of megacap stocks for the long term. For me, the choice of which stocks I would include is not that hard.

I have profiled what I think are the 10 highest quality FTSE 100 shares below. All of them, with the exception of Unilever, are from my watchlist and several I have owned previously. I have set up a dummy portfolio to buy and hold these shares to see how it does against the FTSE 100 and to track my own performance against.

Diageo

Diageo is a global drinks business that owns a number of brands. It’s undoubtedly a high quality business and it’s a business I think you can safely bet is going to continue to be very profitable for a very long time:

• Business economics: Diageo has high margins, good cash conversion and decent returns on capital. While drink production and distribution is somewhat capital intensive, Diageo’s scale and expertise and the strength of its brands allow it to do this very profitably.
• Track record: Diageo (and its predecessor businesses) have a phenomenal track record of growth over the very long term. The share price has steadily appreciated in line with this. Over time certain brands or certain regions go through periods of underperformance, and over the last three years various issues have added up to growth in revenues and profits stalling overall (though now it is resuming). Diageo’s size makes it quite difficult to unpick what the better and worse parts of its business are, though overall it appears very capable of refocusing its efforts or restructuring to ensure continued growth over the longer term.
• Competitive advantage: it doesn’t require much analysis to recognise that Diageo’s main competitive advantage comes from the strength of its brands, many of whom are household names. In addition, Diageo benefits from economies of scale and scope in distribution and has considerable expertise in brand marketing.
• Growth prospects: Diageo’s growth is undoubtedly limited by its size. However, while you can be fairly confident it won’t experience explosive growth in any given year, it has lots of opportunities to incrementally grow sales for its various brands across different regions. Its geographic diversification and the defensiveness of drink sales mean it is relatively unaffected by economic cycles and likely to be able to deliver more exciting compound growth when looked at over the longer term.

RELX

RELX (formerly Reed Elsevier) is a global provider of information and analytics to businesses. It owns huge databases of primary academic research and journal articles and produces analytic tools for businesses.

• Business economics: RELX is a capital light business with high margins and returns on capital. It is highly profitable and has very high cash conversion:
• Track record: RELX has a decent track record, with growing revenues, profits and share price for the past few years. However, prior to that there was a long period where the share price stagnated up until about 2011. I am not sure of the reason for this but I presume the underlying business must have stagnated too. Given its more recent performance has been improving for over 5 years, I wouldn’t put too much weight on this.
• Competitive advantage: RELX has a strong competitive advantage from all the IP it has acquired and developed. It faces little competition and generates much of its revenue from recurring subscriptions.
• Growth prospects: it is a fairly defensive business enabling it to grow throughout the cycle. The market it is in appears likely to benefit from secular growth. My main concern is risk of regulatory intervention, as there are many who do not approve of the commercialisation of academic content. I don’t think this risk is very likely to materialise in the near future but with the right catalyst who knows. RELX appears to be mitigating this by refocusing its business away from subscriptions towards developing more sophisticated analytical tools.

Micro Focus

Micro Focus is a global software business. I’ve held the shares until quite recently and have previously written about it here. To recap:

• Business economics: Micro Focus business has great economics: it has huge margins, ROCE and FCF conversion. It is able to generate very high profitability from its customer base without much investment.
• Track record: Shareholder returns have been exceptionally and consistently high in recent years, particularly for a large company. Micro Focus is one of very few companies whose share price grew through the 2008 downturn.
• Competitive advantage: Micro Focus is largely almost totally insulated from competition for existing customers who are effectively locked in to using its products. Even more widely it faces little competition. It also benefits from scale and operational efficiency and appears to be well run.
• Growth prospects: this may be its relative weakness. The market it operates in is stable in the long term and its products are indispensable to its customers. It therefore makes stable profits and is very defensive. This allows it to generate decent growth throughout the cycle. However, it appears a fairly mature business. There are some areas of growth for its products, though Micro Focus recent strategy has been to grow by driving consolidation and greater efficiency across the sector. It appears to be executing this strategy very successfully so far, though it comes with some risk.

Sage

Sage is a global provider of IT for managing payroll and payments.

• Business economics: Sage has good business economics. It has high margins and returns on capital. It has very low capital requirements and very high cash conversion.
• Track record: Sage has a good track record with steadily appreciating profits and share price over the longer term. In recent years there have been some ups and downs, particularly in respect of its US payments business that it is now selling.
• Competitive advantage: Sage is a similar business to Micro Focus in that it supplies a service that customers find indispensable and face high costs to switch suppliers. It also benefits from scale and from its IP and know-how. I believe Sage has a strong competitive advantage that is likely to endure.
• Growth prospects: Sage appears to have very good growth prospects for a business of its size. It is winning customers with new cloud based products in a market that faces long term secular growth. Over the longer term I’d be very bullish on Sage’s prospects.

Intercontinental Hotels Group

IHG is the only FTSE 100 company currently in my portfolio. IHG is a hotel brand owner and franchisor (and manager). Other than a handful it no longer owns its own hotels. They charge a royalty fee which is a percentage of revenue earned by their franchisees. I think it is an excellent quality business:

• Business economics: IHG has an asset light, franchise business model and corresponding excellent margins (40%) and returns on capital (consistently > 30%). IHG invests to develop its brand and in technology to improve the consumer experience. I think the business model is really excellent.
• Track record: the track record is pretty good with modest compound growth in earnings and cashflow over the last few years. The share price has done very well.
• Competitive advantage: I believe the hotels market is fairly competitive. IHG’s competitive advantage must come from the strength of its brands. Its high margins and growth suggest these brands are valuable. I don’t have any particular insight into how sustainable and strong these brands are but I am attracted by the fact that IHG franchise business model means its focus is entirely on continuing to develop and invest in these brands.
• Growth prospects: IHG is quite a large company which often makes further growth prospects a concern. In this case I think IHG has good growth prospects particularly as it operates in a very large growing global market with lots of scope for increasing market share. I think the hotels market is somewhat cyclical but the franchise model more or less eliminates financial risk from this.

Hargreaves Lansdown

Hargreaves provides a number of different investment services direct to individuals, predominantly in the UK.

• Business economics: The business has really great economics – costs are pretty low and fixed and it is able to grow without too much capital investment so a large proportion of revenues turn to profit and a very large proportion of profit turns to cash. Most of its revenues are recurring from existing customers.
  The numbers are consequently very impressive with exceptionally high margins, ROCE and FCF conversion.
• Track record: Hargreaves has a very good track record. It has grown profits fairly consistently for a number of years and at a fast rate.
• Competitive advantage: Hargreaves appears to have a competitive advantage based on its brand, reputation, technology and customer service. It is a high price high service provider. This competitive advantage is demonstrated by its high and growing market share – it is the leading provider with about 38% of the market. It may face greater threat from low cost providers in the future.
• Growth prospects: Hargreaves is in a market with secular growth and appears to have opportunities to grow through adding new products. However, it already has a very high market in the UK and little global reach and it is possible this may hinder growth in the future. In addition, some of its fees relate to assets under management and so will rise and fall in line with the stock market. It is therefore cyclical to some extent. It faces possible regulatory risk, though the market is already fairly well regulated and I believe drastic negative impact on its business from regulatory change is unlikely.

Paddy Power Betfair

Paddy Power Betfair needs little introduction. It is the product of a recent merger between Paddy Power, the best performing high street bookmaker, and Betfair, the innovative betting platform, where users can take opposing sides to each others bets.

• Business economics: It is slightly difficult to interpret Paddy Power Betfair’s figures because of the recent merger. However, before the merger it is clear that both businesses were earning high margins and returns on capital. Both businesses are naturally highly cash generative have a very substantial online focus.While the fixed assets / retail aspects of Paddy Power’s business are somewhat unattractive the brand is continuing to grow and take market share from its competitors.
• Track record: Both Paddy Power and Betfair have excellent track records for growth in recent years. Obviously the merger complicates things and it appears to have possibly resulted in higher costs than expected though all operating divisions of the combined business are experiencing double digit growth in revenues.
• Competitive advantage: Paddy Power Betfair’s competitive advantage appears to be immense. It benefits from cost advantages from its scale. It owns two very strong and complementary brands with some of the best technology and customer features. Betfair in particular offers quite a unique proposition, while Paddy Power has an advantage over its rivals from sheer scale of marketing budget. Technology and scale advantages appear to give the business a substantial advantage over its competitors in pricing as well as allowing it to offer betting on a very wider range of events.
• Growth potential: given this business is larger than those I tend to invest in, growth potential is important. Pleasingly, the business appears to have a huge amount of scope for further growth from further increasing market share, international expansion where it is already starting to become well-diversified, introducing new products and secular growth in its markets, particularly online. I think it has the potential to become a real global leader. In gambling the risk of regulatory change is ever-present and, while I cannot see imminent threats (e.g. Paddy Power does not operate fixed odds betting terminals), I think is a drawback for investing here.

Burberry

Burberry is a manufacturer and distributor of luxury good and fashion items. Its Burberry brand is sold globally but is particularly popular in Asia. I like brand owning businesses and this is the largest of the four fashion brands on my watchlist, the others being Ted Baker, Supergroup and Boohoo.

• Business economics: Burberry has great business economics and is very profitable. It has high margins as a result of being able to sell its products at premium prices, it has consistently high returns on capital and it generates a lot of cash.
• Track record: while Burberry has succeeded in growing over the long term its track record is a little patchy with ups and downs in the profits it reports and consequently the share price. I note the share price was hit fairly hard by the financial crisis.
• Competitive advantage: Burberry’s competitive advantage comes from its brand. I am fairly confident in the strength of its brand just from my own observation of it. It has managed to preserve its association with high quality well and seems like the sort of brand that is likely to endure.
• Growth prospects: given its large size and recent patchy track record, I’d be most concerned about Burberry’s growth prospects. It is not so large that it doesn’t have ample opportunities to grow geographically and with continued product development, though I feel somewhat less confident about Burberry’s long term growth prospects than some of the others on this list.

Compass Group

Compass is a caterer, predominantly providing outsourcing services to large businesses. It is a holding I sold recently.

• Business economics: Compass is not really a capital light business but it does have consistently very high returns of capital and turns profits into cash, suggesting its capex investments are generally highly profitable. It doesn’t have great margins but that is to be expected from a business of this type.
• Track record: Compass has a phenomenal track record and has steadily grown profits and cash flow over many years. I note its share price was not very negatively affected by the 2008 downturn. It looks like a very stable and profitable, growing business. It looks like a classic defensive compounder.
• Competitive advantage: Compass has a competitive advantage from its scale and distribution network, which enable it to provide a higher quality and lower cost service to multinational businesses. It has long contracts for which it may have an incumbency advantage in retaining. It is very well diversified across its customer base.
• Growth prospects: Compass is in a market with secular growth due to a shift towards outsourcing. There are no apparent technological threats. Though some of the business is commodity related overall it is defensive. My one possible concern with Compass is the extent to which it can continue to grow given its size though there still seems to be plenty of runway right now.

Unilever

Unilever needs no introduction and the business many UK investors would first think of if asked to name a high quality defensive investment. It’s not on my watchlist simply because of its huge size (it has a market capitalisation of about £120bn). It’s undoubtedly a very good business to hold for the long term. It is of course a global business that owns many fast moving consumer goods brands (e.g. household products).

• Business economics: Unilever is a highly profitable business with high returns on capital and high margins for a manufacturer of consumer goods. The profitability of Unilever’s business is remarkably consistent. It does have fairly substantial capital requirements but is able to manage these very well. It has clearly got very good at what it does.
• Track record: Unilever has an excellent track record with fairly consistent growth in revenues and profits for many years. It is clearly a defensive business and its share price was not affected much by the financial crisis.
• Competitive advantage: Unilever has competitive advantages from many sources: economies of scale and scope in its manufacturing and distribution network, its huge range of brands give it negotiating strength with customers (like supermarkets) and its expertise and IP in product development.
• Growth prospects: growth prospects are always going to be the concern with such a large business. However, while I wouldn’t expect particularly exciting growth, the defensiveness of the business and likely growth in the overall market (particularly in emerging markets) mean that over the long term I’d expect pretty decent returns.