I recently read the absolutely wonderful book which is jam-packed with many insights and nuggets of wisdom on investing in quality companies. It definitely deserves a place on every serious investor’s bookshelf. It’s not that the concepts are groundbreaking but they are clearly articulated and weaved together in a manner that provides further food for thought. Reading the book provides a timely reminder of what it means to be picking exceptional companies.
However, I also recognise that buying great businesses that are clearly understood is insufficient. To make the big money, one has to find the businesses as they are building their moats rather than after, when their moats are fully established and mature. An example would be investing in Microsoft when Bill Gates was at the helm in the early years, rather than when the competitive strengths are well recognised after Steve Ballmer took over. It is of course easier said than done. That is precisely why I think the book is essential reading to help recognise the type of companies a portfolio should hold while the underlying businesses compound their way nirvana.
In this entry, I’ll highlight 7 key points in the book which I thought stood out the most for me.
On 3 key factors necessary for a business to generate great returns
“In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.” (pg 2)
High ROCs by themselves will not generate great returns for long
“It is relatively easy to identify a company that generates high returns on capital or which has delivered strong historical growth — there are plenty of screening tools which make this possible. The more challenging analytical endeavor is assessing the characteristics that combine to enable and sustain these appealing financial outputs.” (pg 3)
Clues of competitive advantage from analysing gross margins
“Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it… Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it.” (pg 21)
Presence of older players signs of a less competitive industry
“Observing many older players in the industry is also encouraging – it’s a sign that long-term survival is possible.” (pg 39)
Companies selling products that go into the mouth or skin may be potential gold mines
“Intangible benefits often matter more to customers the more intimate the products are. Products that go in the mouth or on the skin carry more intangible potential than those that sit on a table or go into a machine, explaining why most people give the cost of their preferred toothpaste less thought than the price and brand of dishwasher detergent. This is one of the reasons why certain consumer products companies, from edibles to cosmetics, have proven to be such strong businesses over time.” (pg 45)
Why businesses aiming to sell to customers’ capex requirements are more vulnerable
“A business that is solely linked to customers’ capital expenditure makes for a much more complicated investment than one linked to their operating costs. In most cyclical industries, capital equipment is purchased amid periods of capacity expansion… On the other hand, for a company whose profits tie to customers’ operating costs, cyclicality poses less risk of disruption and remains relatively predictable.” (pg 28)
Learning from our own and others’ mistakes
“If smart people learn from their own mistakes while wise people learn from the mistakes of others, the goal is to be both smart and wise. The best thing to do after making or observing a mistake is to acknowledge it and absorb the relevant lessons to avoid repeating it.” (pg 158)