Book-review: Quality Investing (Cunningham)

As quality investors, a major part of how we define greatness is the durability of the economics of the business (…) seeking companies boasting a combination of traits that overcome the forces of mean reversion.

(as in my previous book review I focus more on my learnings/insights/personal summary vs writing style etc.)

I started the book after finishing The Worls for Sale, looking at my list of books to read, the first entry was a recommendation during an application process for an equity analyst role, which was, again, not successful in the end, but as often a further recommendation to another company.

When reading the first two pages, PRAISE FOR QUALITY INVESTING, I knew the book will be a great read, merely reading comments from Russo, Gayner, Mihaljevic, and others, and including references to other great reads.

[WARNING: this became much longer than anticipated, but I realized I would probabaly use this as a puzzle piece for my check-list(s)]

If you prefer to read the pdf version click here. (links may not work in pdf)

1: Building Blocks

Defining Quality is not easy, yet we recognize it when we see it. The below three core attributes enabling a virtuous circle of cash generation. The critical link between growth and value creation is the return on incremental capital.

  • Strong, predictable cash generation
  • Sustainably high returns on capital
  • Attractive growth opportunities

Capital allocation decisions are critical for creating or destroying shareholder value. Working capital considerations are not to be dismissed. (About Capital Allocation – searching 4 value (wordpress.com))

Return on capital is a measure of the effectiveness of capital allocation decisions.

Multiple sources of growth. Growth can come from a variety of sources like growing end-markets (volume), from weak competitors that constantly lose market share (share donors) enabling constant market shares gains, or from higher prices.

Good management is not the most important trait. Anyway, management’s quality is often over-/underestimated if the company’s fundamental development has been strong/weak in (recent) history.

Industry structure is important and sets the stage for quality companies. The entirety of structures has to be analysed.

  • Oligopolies with only two competitors are often worse than multiple competitors, since the former situations motivates to beat the one competitor every single time (value destructive) while it is obvious one will not beat various competitors all the time.
  • Customer structures are important besides competitors. Better to sell small-ticket items to many customers daily (Coca Cola, Pepsi) instead of selling expensive tickets seldomly to a small group of customers (Boeing, Airbus), resulting in fierce negotiations.
  • Similar dynamics apply to supplier structures.  

Customer benefits should be derived from a quality companie’s products. There are intangible, assurance and convenience benefits.

  • Loreal is a master of intangible benefits (brand, perceived advantages). A tub of its creams often costs multiples of competitor e products, and might! offer a small advantage, but these are seldomly tested –if ever.
  • Assurance benefits rest on reputation. To compete against reputation is often impossible. A buyer of a parachute will most certainly buy the higher priced product of a well known brand, since the perceived slightly higher probability of failure with catastrophic outcomes for the cheaper seller is deemed not enticing enough. Same holds for suppliers of small/cheap but critical components.
  • Convenience benefits can simply arise from a product being readily accessible, such as the local restaurant which is neither the tastiest nor the biggest quality.

Customer types are relevant for business quality. Consumers are willing to splurge on some occasions — mostly on small ticket items with intangible benefits (preferred chocolate bar) — and can often time sbe fickle and price sensitive. Corporate customers of smaller size tend to act as consumers, but the bigger they are they behave like ‘true’ corporate customers, that pay less for intangible benefits but apply professionalized purchasing decisions sometimes using procurement departments. Their buying decisions tend to be more objective. Risk aversion is important, on the corporate and the individual level (nobody got fired for buying IBM). Big ticket purchases get a lot of management attention (committee sign offs).

  • If you sell to consumers, it might be better so sell items with intangible benefits (brand, etc).
  • If you sell to corporates, it is preferable to sell small ticket items that are crucial, and items that are not bought via organized bidding processes. The more buying decisions are driven by price rather than other factors, the less attractive for the seller.

2: Patterns

When looking for quality companies, the desired outcomes are the same — strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities — but the routes to achieve this status are numerous.

Recurring revenue limits financial pressure during cyclical downturns and often results in negative working capital, since subscriptions and service revenues tend to be billed in advance. An installed base in software and manufacturing (elevators, aircraft engines) industries often comes with attached high-margin service and maintenance contracts. Subscriptions can be cancelled, thus they work better if integrated into processes (i.e., credit scoring data providers within a bank’s credit department).

Friendly middlemen can result in strong product sales advantages. Optometrist act as physicians diagnosing patience‘s eyes, but then recommending (stylish) eyewear products to their customers maximizing dollar margins. Craftsmen tend to install pricier products, then their end-customers would choose on their own, to enjoy benefits like product know-how (can be supported by sales activities and trainings), higher quality and reputation (if a product breaks quckly it damages his reputation).

Toll road like businesses extract value per unit sold in their end industries and can result from their status as gold standard or providing magic ingredients. Rating agencies and quality assurance companies can reach gold standard status on the basis of reputation and enjoy good profits in their industries. Training can results in a strong market position as well (excel, CAD software), especially if students use/learn these tools (good strategy to offer discounted/free student/university software). Providers of critical but rather cheap components vs the total value within a bigger products/process (magic ingredients) can be high quality businesses. Examples are enzymes for yoghurt (Chr. Hansen) or industrial gases / lubricants. (Here is a thread with some magic ingredients producers)

Low price plus expresses the need for a quality business to have more than merely lowest prices, currently. These competitive advantages do not last usually. Instead, a business can conquer consumers minds as a quality low price seller (and obscure comparison possibilities), or gain many cost advantages along every step of its business process instead of one single source.

Pricing power is the ability to raise prices above inflation without losing volumes. It is often obscured by talking about new product features/upgrades while raising price. It results in sales and profit growth without investment needs, thus enhancing capital returns and should result in high/increasing gross margins. It can result from (luxury) brand power. Conditional pricing power can be found in locked in service contracts. Pricing for value refers to product improvements shared between producer and consumer (i. E. Monsanto, farmers). Price deflation refers to the opposite: prices decline longer term, often with rising volumes (technology hardware).

Brand strength can result in fans (apple) in one of its strongest forms. Brands enjoying a strong heritage (Cartier, Ray Ban) are impossible to replicate: no amount of capital can reproduce such a history.

  • Tech brands risk to lose appeal if industry innovation and trends are missed.
  • A scale advantage results from higher absolute marketing spend, can be lower per revenue dollar (comparable to R&D budgets, ie Intel), and distribution advantages.
  • A strong brand can drive growth, ie expanding into new (related) product categories, ie parfume after handbags. Too many products can dilute the brand, though.

Innovation dominance should be underpinned by scientific curiosity, high(er) abolute R&D spending and efficiency.

Forward integration gives companies more influence over customer experience, and, under the right conditions can be hugely valuable.

  • Store ownership (highest control over brand experience, ie Pandora A/S)
  • Franchising (growth funded by third parties, relatively stable revenues during recessions)
  • Licensing
  • E-tailing (better data usage?)

Market share gainers enjoy the possibility of growth without a growing market/economy and reinforce some comparative advantages through their scale (R&D, advertising). Further, stakeholders (suppliers, employees, distributors) prefer to bet on the winning team.

They must not win market share quickly or every single period. If expenses increase strongly, it may be better to raise costs ahead of competition and letting market share slide (ie insurance industry with high CR).

In industries with long times between growth and economic profit (ie banking, insurance), growing is easy (reducing lending or underwriting standards). In these industries, good companies tend to cede share in booms and gain share in economic downturns.

Global capabilities and leadership does not refer to size primarily but to a set of capabilities to adapt, being rich in experience. The most powerful domestic company may fail when a foreign competitor enters its market. Tesco failed in the US, Yum’s KFC and pizza Hut succeeded in China (with a very different menu).

Corporate culture with common values that drive success for quality companies should be found throughout the company. Cost consciousness for a low cost producer, collaborative production for a certification business. The handling of bad news is a good signal on trustworthiness. A focus on the long term goes against maximizing short term earnings. Allocating capital to R&D and measuring return on capital are good signals. Timely execution is a reason for employees to go the extra mile, and further it signals corporate ability to manage costs and deep knowledge of their markets. Cultures tend to self-perpetuate. A new employee will not raise ethical standards if the company’s culture does not support this.  Rule benders will choose their employer and act accordingly. Family ownership, not family management, is a strong signal for long term focus.

Cost to replicate inverses the analysis of competitive advantages and askes for the cost (and time often costs money) to replicate.

3: Pitfalls

Cyclicality is a risk to business profitability and makes the investment proposition much more difficult. Selling to customers that face cyclical end markets can be much better if customers recognize it as OpEx instead of CapEx (more cyclical). OpEx related prices of services or products can be rather stable for flow products, which demand depends on production volumes in end markets. Cyclical downturns motivates a many companies to reexamine costs, even of such flow products which usually are less scrutinized VS big one time project CapEx spending. Very long cycles can hide cyclicality. Cyclicality makes business analysis complex and prone to error, ie we could, in theory, calculate the sustainable growth rate over a very long term period, including various cycles, but that only helps so much when the nature of business has changed. Thus understanding businesses with direct or indirect exposure or links to cyclicality is more difficult.

High quality businesses become more valuable with cyclicality, ie when they invest opportunistically.

Technological innovation poses a risk to established businesses, especially if it is big (instead of small increments) and fast-paced innovations. The losers in an industry experiencing innovation and disruption are easier to detect then the ultimate winners.

Dependency results from factors outside of a company’s control. Governments can change a business’ fortune on a whim, changing legislation, or applying some form of higher taxes. Companies with fixtures (oil and gas, mining, Telco, utilities) are most at risk here, because they can’t leave. To provide an example against the prevailing zeitgeist: renewable energy subsidies in Europe we’re cut after the GFC, delivering a blow to the industry. A mighty stakeholder also brings risks, to extract economic profit.

Shifting customer preferences can inflict economic damage. Brands can become uncool. Good-enough goods mostly undermine high margins of branded premium products that may have rested on presumably higher product quality, such as reassurance. Supermarkets sell private labels nowadays, which I tend to buy, pressuring branded premium products and shifting the power balance.

4: Implementation

Short term dynamics and when quality companie’s reach seemingly rich valuations can result in urges undermining our goal of owning high quality businesses for the long term.

Challenges are short term thinking, our preference for hard numerical data over qualitative factors, quality companies are not the most exciting investments, and they will often appear expensive.

Short term thinking. Over a one period there will be many securities with much higher returns than the average high quality investment. But never forgwt: what counts is longterm returns after transaction fees and taxes.

In periods of economic recovery ‘junk’ tends to outperform ‘quality’ but (i) these periods are rather rare and (ii) as Terry Smith concludes ‘quality companies’ have nothing to recover from resulting in a good chance of superior long-term returns.

Numerical data is abundant in the investing profession and creates a sense of false security. After all, data has to be interpreted and, ultimately we have to conclude if it supports our thesis (usually marred by various biases). Making assumptions is of course not that much better (imagine deciding on future growth rates).

Being dull in an exciting profession often interpred as a treasure hunt: to find a hidden gem in obscure market segments seems like a promise for riches. Investing in quality companies that seldom ‘hidden’ is quite dull against analyzing what is often in plain sight, despite them often looking expensive when compared to ‘market multiples’ quality companies might often be not expensive enough (for fair returns).

Mistakes when buying include top-down analysis and decisions instead of building necessary conviction by micro-analysis of single firms, optimism for improvements often results in disappointment when firms do ultimately not improve, often due to external industry factors that can’t be tackled by management or turnarounds that seldom turn, and even if we try we can fail two times as often that is when buying and when selling.

Overconfidence is everywhere in the investing world, and it is even higher when dealing with companies that depend on external factors outside of there control, as politics, technological change, commodity prices, and very complex companies, ie Siemens with a whole range of segments (some spun off now).

Debt is often seen positively in an investment case. Two common mistakes are combining financial leverage with high operating leverage resulting in acute problems in a downturn and not being aware of debt resulting from retail leases.

Mistakes of retention includes sticking with boiling frogs, a reference to believes that frogs jump out of boiling water but stay in water gradually heating up until boiling. High quality companies seldomly deteriorate to low quality within a single quarter, but mostly do so over time. Realizing that they deteriorate is critical, even if management might tell a story of (many) one time issues.

Ignoring market changes can result from weaker customers cutting budgets, from technological changes, or many other factors.

Thesis creep or ‘yes, but’ mistakes result from the acknowledgement of difficulty filled by a negating qualification.

Accounting red flags are when judgements move beyong reasonableness, and often occur when businesses are deteriorating, ie declining revenue quality showing as earlier revenue recognition and faster growing accounts receivable ahead of sales, or capitalizing more R&D costs.

The endowment effect is especially problematic in quality investing for the long term since our considerable time spend on analyzing the company magnifies our attachment to our owned positions. Asking would I buy it today for my portfolio? can help.

Valuation and market pricing are of secondary consideration within a quality investing approach. Valuation methods come with its limits and our biases, thus focusing on quality first. Valuation premiums regularly fail to be high enough for quality stocks,even if multiples seem rich. One reason is short term incentives in the investment world.

Investment process and mistake reduction can be achieved with wide research or scuttlebutt. That is assessing the business/investment from different angles. Mistakes can be reduced with checklists. Analysing ones past decisions also helps, though tricky and unpleasant.

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As quality investors, a major part of how we define greatness is the durability of the economics of the business (…) seeking companies boasting a combination of traits that overcome the forces of mean reversion.

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A dream company would have

  • Recurring revenue, or uncyclical
  • High margins
  • High returns on capital
  • Ample attractive growth opportunities
  • Strong comparative advantages

Links / other

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