A traditional definition of a quality company checks off these boxes: a significant competitive advantage, high return on capital (which usually accompanies a competitive advantage), good management (skilled at both running the business and allocating capital) and, last but not least, a solid balance sheet. However, there is a simpler test for what constitutes a quality Company:
Would we want to own this business if the stock market was closed for 10 years?Warren Buffett
Vitaliy Katsenelson summarizes what high Quality means to IMA, within their investment process’ first step, in the following way
– Transparent, simple to understandimausa.com
– Significant competitive Advantage
– High recurrence of revenues
– Balance sheet a source of strength
– Management owns a lot of stock
– Intelligent allocation of capital
The Link to Margin of Safety
Within my Value Investing framework, the margin of safety is a very important feature. When thinking about determining the required discount, between potential buy-prices and estimated fair value, for any investment opportunity, it became clear to me, that the margin of safety or MoS should be higher when quality is lower of the underlying business.
My Questionnaire Approach
To get to a more quantitative approach evaluating the quality of a business and hence determine the required margin of safety, I started to think about a concept. As usual, I started reading a lot about the topic (some useful links below). Early in the process I asked myself what might be determining the overall quality of a business? I came up with the following categories and a few questions relating to each category. Maximum points per category are capped at 120. The overall range is capped at 100.
- Financial soundness
Growth. Obviously. But what is growth? Usually it refers to (organic) revenue growth, or growth of earnings or dividends (per share). A combination of these metrics is also possible. (Higher and steadier) Growth is desirable if, and only if, it provides value. It would be easy to grow by lowering prices and sell products below production costs. To find desirable growth-features I am going to ask the following questions
- Is the company currently growing (strongly, organic)?
- Is the growth persistent (resiliency during a crisis)?
- Will the company likely have a long runway?
- Is the companys growth trend accelerating?
- Does the company grow profitably?
- Is the company operating in a growing (core-) market?
- Does the company win market share?
- Are global macro factors (mega trends) a secular tailwind?
High profits (margins) are desirable. Higher margins (gross, Ebitda, Ebit, after tax) provide a buffer for shrinking revenues in conjunction with some fixed costs. Additionally, high(er) margins indicate comparative advantages (pricing power and thus earnings power). Ultimately, a business is worth the present value of its future earnings, thus profits are essential.
- Does the company earn high profit margins (Ebitda, Ebit, FCFF), which are desirable and indicative of a strong moat?
- Are margin trends developing in the right direction?
- Are margins high, relative to peers?
- Does the company earn a high return on invested capital (ROIC), ideally with the opportunity to invest a lot of capital in the future with attractive returns (see moats)?
Financial Soundness. Companies should have appropraite Levels of Cash and Liquidity (as became obvious in March 2020), as even the best businesse have to survive first, to earn high Profits in the future. Net Debt Levels should be within reasonable ranges. Related metrics and some other balance sheet ratios to monitor wihin this context are:
- High equity ratio?
- Low goodwill to total equity?
- Low or approriate levels of (Net) Debt to Ebitda, Ebit, FCFF depending on business fundamentals (i.e. cyclicality)?
- Interest cover based on Ebitda, Ebit, FCFF in an adverse scenario?
- Is the debt schedule stretched out and do debt maturities match with cashflows?
- Near-term maturing debt can be repayed out of operating cashflow, if existent?
- High margins, providing a cushion during downturn?
- High overall flexibility?
It is important to understand the underlying fundamental business operations (i.e. biotechs might be diffucult to evaluate), that the business and finacial reporting are not too complex and that it brings a high visibility.
- Do I, as an outsider, have the knowledge to understand the underlying business?
- Does the business lend itself to accurate long-term forecasting (visibility) of key drivers or inputs within a tight enough range and thus of long-term outcomes?
- Does the business generate recurring revenues, which result in much better near-term forecasts?
- Providing resiliency during unforseen events econmoic shocks.
- Is the business not too complex?
- Some big corporations have so many moving parts (segments, adjustments, reclassifications between segments) that its hard to keep track and establish a view on relevant underlying developments and financials.
- Am I capable of modelling the underlying business sufficiently, using most relevant key-drivers, and do I ultimately trust my model?
- Kind of summarizes various aspects. Businesses with an easy value proposition are usually easier to model with less uncertainty involved.
- Is the financial performance very much dependent on external factors, i.e. commodity prices, fashion trends, regulations?
- External factors are per definition not controllable (luck). Therefor a high dependency increases risk.
A good management is very important for long-term shareholder value creation. Being in the same boat as management feels great as a shareholder and should help a lot to align incentives. Questions to consider:
- Is a good management in place? – Overall perception
- Is the management or some executives with the company for a long time?
- Does management think and act about shareholder value creation in a preferable way? – I.e. like long-term owner-perspective of a business, minimizing risks, long-term value creation.
- Do managers hold significant shares or economic ownership? – Alignment of shareholder incentives with a focus on longterm risk/reward are very obvious then.
- Are (other) management incentives aligned with common shareholders?
- Is the capital allocation strategy reasonable conservative? – Repaying debt (first if appr.), opportunistic share buy backs, dividends and acquisitions or hoarding cash.
- Does the management only get involved in rather small acquisitions that represent a strategic fit? Goals should include strengthening the companys position in core markets or establish very attractive new opportunities, focus on intergration before targeting new acquisitions and not overpaying for showing positive (reported) growth.
Comparative advantages or ‘maots’ can come from several sources. Mostly, they come along with above average profit margins and increase the companys chance of success in the future.
- Does the company has a competitive advantage (moat), what is the source of Moat?
- If it is not easy to explain, there is probably none.
- Multiple sources are superior.
- Does the company has a certain pricing power and earns healthy profit margins?
- This is a strong indicator of a moat.
- How likely will the moat be intact in 10 years?
Estimating durability is difficult, but trying is important.
- How likely will customers value the product/service in 10 years?
- Does the company reinvests in its moat or is it a legacy moat?
Categories in More Detail
Many of the
better best pieces I stumbled about during researching the topic, are from Ensemble Capital published at intrinsicinvesting.com. The three circles depict their concept in a nutshell. I reference to a handful of their write ups below.
It is very important to ealize that dividing investment styles into growth investing (high P/B, P/E multiples) and value investing (low P/B, P/E) is nonsense. I can not phrase it better than Sean Stannard-Stockton from Ensemble Capital:
The world of investing is traditionally divided into growth and value approaches. Growth investors favor buying stocks of companies that are growing quickly while value investors buy stocks that they believe are cheap. But this is a false dichotomy. All else equal, fast growing companies are more valuable than slow growing companies and so any sensible approach to investing will recognize that growth is a component of value, not the opposite of value.intrinsicinvesting.com
With a growing company, time is on your side.
Profitability or high profit margins are indicative of comparative advantages, enabling the company to churn out high profits without competitors being able to chip away at those fat profit margins as economic theory 101 would let us conclude.
When the top line of a company might decline during economic downturns and the cost base does not only consists of variable costs, profit margins get squeezed. Higher profit margins provide a better cushion during challenging times.
Margins are obviously very important since any present value of a company is the sum of the risk adjusted discounted future profits.
A strong balance sheet provides stability during market stress, like experienced in March and April 2020. Companies with higher cash on their balance sheet are better prepared to weather the storm. Low debt to equity and low debt to profit metrics further indicate lowers risk. Interests due should be payed out of casflow from operations, even applying adverse scenarios. Debt coming due in the near future should not result in refinancing needs. In general, debt maturities should be streched out far into the future.
- Path dependency can exist based on (missing) financial strength of a company. Related terms are fragility, robustness and anti-fragility.
As an outsider, modeling and valueing a business makes more sense if it is understandable and the range of outcomes of key inputs/results is not too wide. Commodity prices as a key input clearly contradict that idea.
A certain understanding of the industry is important. Additionally, the financial repoting should not be too complex. After all, that past financial performance is the foundation to build the model upon. Top line wise, recurring revenues make for great forecastability in the short-to-medium term. Longer term the risk of industry trends or specific business disruptions increases the range of outcomes dramatically.
Certain parallels between poker and investing exists. If you hold nuts (the best hand), your uncertainty is low(est) and you can comfortable bet the highest amount.
- Howard Marks from Oaktree Capital comparing Gambling and Investment Descisions based on features as information availability, skill, luck, etc.
Management incentives should be aligned with hareholders. It feels great and shoudl lead to better long term results without excessive risk taking. A good management is very important for long term success, leveraging all of the other categories’ strength, getting the big decisions right, mitigating risks and setting the stage for long term profitable growth. The right capital allocation can lead to excellent long term shareholder returns. Reinvesting earnings or cash into the business taking advantage of growth opportunities, paying dividends, buying back shares, buying competitors or hoarding cash all compete for the companys excess cash.
Why do moats matter? – The necessity for certain business characteristics defending a companys profits, so called Moats, is best explained this way.
When a company finds a place in the economy to earn a profit, there are many other companies that will try to take a piece of the action. Without some type of profit protecting business model characteristics, businesses with attractive returns are likely to be bled out by competitive assaults until returns fall towards some industry average, resulting in just average profits over the long term.intrinsicinvesting.com
Why did Moat Analysis change over time? – As Todd Wedding (Ensemble Capital) describes in The Evolution of Moat Analysis, a few decades ago the primary problem was to acquire Funding for a business and access to capital (or competitors lacking this valuable access) resulted in barriers of entry. Nowadays intangible assets are often more valuable (and important) than tangible assets. Focussing on Price-to-Book ratios might therefore be out of time.
The duration of such a moat enables businesses “to compound the value of the excess returns over time”. There are basically two forces determining the moats duration
- External threats such as
- growing competition, start-ups, new technolgies, growing supplier power, lower buying power,
- but often Moat Erosion Starts Behind the Castle Walls, sometimes illustrated through too little
- R&D efforts (expenses), CapEx levels, focused technology or talent acquisitions, customer focus, driving improvements of the companys (core) products
- innovation vs legacy businesses (cash cows) is a usual conflict
Knowing these moat sources also helps you quickly sort through ideas. If you can’t determine which moat source accounts for a company’s high ROIC, the company probably doesn’t have a moat.intrinsicinvesting.com
- Intangible Assets: patents, brands, proprietary processes, talent
- Apple, Coca Cola, luxury brands
- Cost Advantages: some players have economics on their side and enjoy higher margins based on lower unit costs and/or grab a higher market share competing at lower Prices.
- Amazon, Walmart
- Switching Costs: consumers or corporations might incur too high switching costs (effort, time, risks) making it not worth it to switch to another (better) product, typical examples are software vendors:
- Microsoft, SAP, Oracle, Broadridge
- Network Effects: a product (service) becomes better when more users use it, leading to more users
- marketplaces (Amazon), telephone networks or nowadays social networks (Facebook), payment networks (Visa/Mastercard)
- Barriers of Entry: there can be some profound reasons why competitors do not enter a specific market, such as
- Rules: profits could be protected by explicit laws or regulation, as it applies to drug patents for some limited time.
- Economics: sometimes there is an equilibrium established (Efficient Scale) with above average profit margins that does not result in higher competition, since a potential entry of a new player would drive returns below acceptable levels for everyone, incl. the newcomer. Examples could be pipelines, railroads, utilities.
Ideally businesses have several sources of moats. Apple serves as an eample, having intangible assets (brand, talent, patents) and high switching costs.
Moats and Capital Allocation
There are different kinds of moats with huge implications on capital allocation decisions and future earnings potential, summarized in How Moats Make a Difference, the biggest upside might be offered by so called capital light compounders
- Companies that do have no moat or very narrow ones are out of this scope.
- Companies with legacy moats, can use their excess-cash for
- paying high dividends to shareholders, but beware When Dividends are a Problem; or
- use it opportunistically for value creating acquisitions, buying back shares at cheap prices, or paying dividends
- Companies with reinvestment moats use their cash generated from operations for reinvestments, growing their business while insulated from Competition
- Capital light compounders are companies with strong moats, growth potential, but with limited needs for reinvesting capial, setting the stage for very strong future returns.
- Rob Vinall about management qualities: RV Capital at the 2017 Value Investor Conference – YouTube