Investing in Quality Companies

“In the short-term the stock market is a voting machine but in the long-term it is a weighing machine.”

Warren Buffett

To some degree, I have always cared about ensuring that my approach is focused on investing in quality companies and have therefore used quality as a driver for what to buy and sell. Over the last few years, I have become increasingly convinced that earnings per share are a significant driver of investing returns, and so have worked to concentrate my portfolio into those businesses with the greatest growth in EPS whilst divesting myself of the opposite.

Having said this, when I first started investing, I wasn’t quite as selective about investing in quality companies as I ought to have been and ended up putting money into some objectively poor quality businesses which later came back to haunt me. On the other side of the coin, I also found myself selling out of good businesses ‘early’, losing out on significant gains by snatching too quickly at profits.

The turning point for me was when I was reading comments from Warren Buffet and Charlie Munger, either at one of the Berkshire Hathaway AGMs or in one of their many, many interviews. I’ll have to paraphrase a little but the gist was as follows:

Give investors a punch card with 20 slots and ask them to punch a hole in each slot when they make an investment.

Once all the slots are filled, the investor can never make another investment as long as they live. If you burn through the card in a year, that’s it, you’re stuck with what you’ve got for the rest of your life.

If you were forced to follow that rule then you’d think really carefully about making an investment and you’d also be forced to really invest heavily in it.

This made absolute sense to me – not necessarily the idea that you only ever need twenty investments in your entire life, but that really thinking properly about what you’re investing in is a good idea. It sounds obvious but how many of us are chopping and changing our portfolios every three or four years? For my own part, when I first started investing, I had a turnover rate of about 50%, meaning that half of my portfolio was different from one year to the next.

As a result, I’ve spent time working hard to slow down my decision-making process and take my time before selling out of companies and switching investments. In other words, being more selective about investing in quality companies and forcing myself to take my time when making changes to my portfolio. For the most part, this has served me well and has helped to both protect my capital and capture more gains. This patient approach lends itself well to income paying investments, where every year I wait I get paid to hold my investments, which gradually accumulate returns until the original position is covered (or even exceeded) by the income it has paid.

The quote from Warren and Charlie also made me think about a story I was once told about one of the big brokers who analysed the investment returns of their clients. They looked at the annualised returns of all their customers and discovered that an old man in his 80s had a compound annual growth rate far in excess of all the others. When they looked into his account it turned out he had passed away and no one had shut the account!

I’ve always questioned the veracity of that story (for one thing, I’ve heard multiple versions of it) but the logic made sense to me. It’s far easier to make a small number of decisions well than a large number. You have more time to think through what you are doing, check your decision making process, get a second (or third opinion) with a small number of decisions. You are also more relaxed and therefore more likely to think clearly.

By comparison, making lots of decisions every day is likely to wear you out – this is part of why I try to systemise my approach to investing. If I only have to make a few decisions then I have time to consider them. The more things I can systemise, the less thinking I have to do, and instead I can concentrate on refining the system.

This systematic approach is applicable to both making and divesting investments and again, my approach to selecting investments has changed over time. There are about 1,900 companies listed on the London Stock Exchange. When I first started investing, I took the FTSE 100 (the 100 biggest companies on the exchange) and started trying to knock names out that I DIDN’T want to own. These were the businesses with lots of debt, or low profit margins, or declining revenues, or in sectors I didn’t like (Oil & Gas) – it wasn’t particularly difficult to eliminate names.

I gradually expanded this approach to encompass more and more of the market but this presented me with a new problem. For every name I put on my “do not touch” list, I would find three more that I liked. The ‘system’ was beginning to creak as I found more and more opportunities I thought were mispriced and began concentrating more on price than quality.

As careful as I tried to be, the mistakes soon started creeping in as I invested in businesses that weren’t the best of the best (they weren’t even the best of the worst). If I had committed more time to thinking about the initial investment decision I would likely have avoided some of these.

To remedy this, I began to focus on investing in quality companies again, and am trying to be ruthless about it. After all, you might make 5% a year by flipping lots of small opportunities, or you could compound a fantastic business at 15% a year by focusing on quality.

What do I mean by quality?

A quality business could mean many things to different investors. Quality to one investor might be the ability to pay out a high yield in dividends and increase those dividends every year for many years. To another, it might be the ability to grow revenue at a high rate, or to build and maintain a high profit margin.

To me, a quality business has a number of characteristics:

  1. Generates significant revenue (nothing sub-£50m)
    • Revenue equals sales. Without revenue, an investor has no idea if what the company is doing will ever be in demand – it isn’t at the moment so why would that change? The lower the revenue, the smaller the demand for their goods and services. This isn’t to say that all low-revenue or pre-revenue businesses are low quality, simply that a key indicator isn’t in place (significant commercial demand).
  2. Growing revenue at a rate faster than inflation
    • Revenue growth indicates increasing demand for a company’s goods or services. The faster the growth, the greater the demand. If a company is producing a good or service that is in high-demand then it follows that it is likely to have the potential to become a market-leader.
  3. Strong and stable profit margins (10% minimum)
    • Revenue without profit is meaningless. If I sold pound coins for 50p then my revenue would be immense but I’d soon be bankrupt from the losses.
    • A small profit is less desirable than a large profit. With margins of only 1%, a business only has to have a few things turn against it to become loss-making. The stronger the margins, the stronger the company.
  4. Ability to operate with limited debt and equity issuance
    • Debt and equity issuance are a little like sugar. They provide an immediate cash boost to a company but over the long-term can weaken it through interest payments and shareholder dilution. The best companies generate profit and reinvest this without the need to constantly raise outside capital.
  5. Strong returns on capital employed (10% minimum)
    • A company’s return on capital (ROCE) employed assesses how well a company generates profit from the capital (debt and equity) it is using. Capital has a cost and the best companies use low cost capital and generate high returns with it. This becomes increasingly important as the cost of capital increases and the higher a company’s returns are, the easier they are able to do this. A consistently high ROCE indicates that a company is generating attractive returns, improving investor confidence and reducing the cost of capital.

Of course, all of these metrics are also historical in nature, and as well all know, past performance is no guarantee of future returns. As such, part of my assessment of quality companies is also forward looking, in that I’m attempting to make an assessment of their prospects over the next few years. If the business has successfully demonstrated the characteristics listed above, I can be reasonably confident that it is a well-run business and as such ought to be considered as part of my approach to investing in quality companies.

My next determination is then to assess how likely I feel the characteristics will remain in place. To do this, I look at another range of issues including:

  1. The consistency of the characteristics
    1. A company which has had a temporary spike in revenue or profits is less likely to maintain it than one which has consistently demonstrated stable or growing returns over ten years. Instead, I am looking for businesses which have demonstrated low volatility of earnings over a ten year period.
  2. Sector dynamics
    1. A company could benefit from a temporary obsession with their goods or services that doesn’t reflect underlying demand. Retail companies can be particularly susceptible to this as fashions come and go. If an investor fails to recognise the nature of this demand they can end up investing in a business during a period of favourability that later declines.
  3. Predictability
    1. The cause of demand should be understandable to me as an investor – without this I am simply hoping that demand remains stable over time. If I can’t understand what is driving demand then I cannot assess how likely it is to remain.

What are the benefits of investing in quality companies?

Companies with the characteristics listed above tend to have higher levels of profitability and resilience during different market conditions. This is reflected in higher growth rates, stronger returns on capital, and as a result, better shareholder returns. If we take earnings per share as the main driver of shareholder returns, then those earnings are boosted above and beyond those offered by lower quality companies by higher growth rates of revenue and profit, lower issuance of equity, lower use of debt, and more resilient demand during periods of economic turbulence.

As a result if this, these companies tend to generate more cash, are more able to sustain and grow their dividends, more easily able to service their debts, and are more likely to retain these characteristics over time. Investors are therefore rewarded with high rates of return not only because initial earnings are higher than alternative investments, but because these companies benefits from higher growth rates and for longer periods of time than their competition. This outperformance is reflected by a stream of positive news which is rewarded by the market with higher valuations over time.

By focusing on the metrics set out above, I aim to keep my approach narrowly fixed on investing in quality companies, at which point I can then start considering when I might be able to purchase them at a discount to their intrinsic value. Over time, I am seeking to relentlessly drive up the quality of my portfolio, ignoring the lowest quality businesses and focusing on the best. In theory, this should ensure that as a whole, the earnings per share generating by my investments increases and therefore the portfolio becomes more valuable over time.

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