Expounding on ‘Quality’ of the QVG framework

Under the Investment Philosophy page, I mentioned that I assess moat-type investments on a Quality, Valuation and Growth framework (QVG). In this post, I’ll expound in greater detail on the assessment of ‘Quality’.

As different variables and scenarios arise from each investment opportunity, it will be hard  to list each and every condition to determine quality. To simply matters, other than the key conditions I look out for, I have also laid out the ideal situations which would likely lead me to invest in a quality business.

Broadly, I categorise quality into 2 buckets – the qualitative and quantitative aspects.

I have also included a diagram or flow chart of sorts to summarise the below-mentioned points for easy and future reference.

quality-chart

 

Qualitative

One of the first things I try to identify is the type of economic moat(s) a business possess(es).

“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well.” – Warren Buffett

The moat, in a way, refers to competitive advantages. Its usage in the world of investing appears to have caught on after the repeated usage by Warren Buffett in the Berkshire letters and during interviews.

If Warren Buffett was the father to popularising the ‘moat’ term, Pat Dorsey would be the intellectual offspring who expanded the topic on moats. Pat Dorsey was the director of research at Morningstar and wrote the wonderful books, ‘The Five Rules for Successful Stock Investing’; and ‘The Little Book That Builds Wealth’. In these books, he covered in great detail how to analyse moats, what makes them great and has a number of examples to show for.

Type of moat(s); 2 is better than 1

To keep the long story short, Pat Dorsey identified 4 economic moats that exist in strong companies generating excess profits:

  1. Intangible assets – Brand, patent, license (eg. Coca-Cola)
  2. Customer switching costs (eg. Adobe)
  3. Network effect (eg. Facebook)
  4. Economies of scale (eg. Walmart)

Plenty has been written about the topic so I shall not go into the nitty gritty details of each moat. I have included in brackets above, my own examples of well-known companies that fall into each categories.

Over the years, I came to realise that for a business to be truly great, 1 standalone moat is insufficient. Although one moat is typically more dominant than the other, there usually needs to be a strong combination of at least 2 moats concurrently driving the business. As an example, while Coca-Cola definitely has the dominant intangible – brand moat driving its success, its operations also has huge economies of scale at the global level. This helps the company to generate greater profits (stemming from lower cost per unit) in excess of what another strong beverage brand that is just a small local player may otherwise achieve.

Sustainability of moat(s)

Once the type(s) of moat(s) is/are ascertained, the next step – which is a crucially important step – is to assess how sustainable the moat(s) is/are likely, measured in number of years. The more sustainable the moat is, the longer the duration of excess cash flows flowing into the business that will ultimately benefit shareholders.

Determining the duration is not an exact science and there is a large element of guesswork. However, there is one clue to this. The reality is that the most likely source of disruptive force affecting any business stems from technology.

As such, one of the key questions I seek to answer for each investment case is the chance of technology disrupting the dynamics of the core business. In the case of gum chewing, the internet and pace of technology change is unlikely to disrupt consumers’ habits. In my opinion, I think there is a high degree of certainty that in 10 to 20 years from now, I will continue to chew pretty much the same Wrigley’s gum I do today as I did decades ago.

In comparison, I cannot be certain my laptop will be from Acer. In fact, given the pace of change in the field of electronics, I cannot even be sure I’ll be using a laptop in the next 10 to 20 years, not to mention that I already have an iPad tablet. In short, the further away the core product of a business is away from having a remote possibility of being affected by high technology, the slower the rate of change and the higher the odds of investments being safe.

That said, I am not advocating staying away from all technology-related stocks. That would be foolish since technology is going to feature in a larger part of our lives in the future. There are some truly great businesses that have stood the test of time, such as Microsoft and Adobe. As an example, Sapiens International, a insurance software provider which I wrote up on, has its software deeply embedded in its clients’ core operations. Once the mission-critical software is installed and the employees of its customers are trained on it, it becomes very hard for the software to be ripped out without its clients’ suffering downtime. Thus, while Sapiens International is a technically a technology firm, these huge switching costs and the customer stickiness that comes with it, should extend the business’ sustainability and correspondingly, the duration of the cash inflows.

Ideally, the sustainability of a great business’ moat should last at least 20 years.

The ultimate test – pricing power

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” – Warren Buffett

Ultimately, the essence of assessing the strength and sustainability of moats boils down to finding out if the business has pricing power. Strong pricing power, in my opinion, is the true test of a business’ quality. I have found it useful in answering early in the analysis, the question of whether a business has pricing power. It acts as a quick sorting filter on the quality of businesses

As shared previously in the post, ‘Pricing power – The rocket fuel to any investment thesis’, businesses with true pricing power has the advantage of ‘raising prices (revenue) without a corresponding increase in its cost base (expenses). In other words, the extra boost in revenue falls directly to the bottomline and provides a magical boost to profits without lifting much of a finger.’

 

Quantitative

Income statement and cash flow

It goes without saying that in an ideal situation, a quality business would see revenue, profit and operating cash flows rise annually at a good clip over at least the past 5 to 10 years, and is expected to do so going forward. The definition of good clip could at times be subjective. Generally, I would be satisfied with a consistent 5% to 15% annual growth rate for the top-line and a correspondingly similar or higher clip for the bottom-line. Too low and it may call into question how good the business and the sector really are; too high and it will surely attract excessive competition that will eventually drive down returns.

In a way, when it comes to assessing financials, I prefer a Goldilocks approach, not too cold and not too hot.

On profit margins, I am agnostic on whether it is low or high on a standalone basis. Profit margins by themselves do not tell much about the quality of a business as the levels are very much dependent on the nature of the industry and business. For example, even though a supermarket business has low margins, it should not warrant striking it out as a potential investment. The nature of a supermarket business (eg. Walmart) is that of low margin, high volume. In comparison, a luxury goods business (eg. Tiffany’s) has the exact opposite features – high margin, low volume. Both can be fantastic businesses.

When it comes to assessing margins, the real test is to benchmark them to its peers within the sector and industry. Needless to say, a high quality business’s margin should be within the top quartile of its group.

To draw inspiration from Lord of the Rings, the one financial metric to really rule them all is the businesses’ returns on capital (“ROC”). ROC, in my opinion, the one metric that will tell a strong business from a mediocre one, regardless of whether the nature of a business is high or low margin. The topic will be further discussed under the section below.

It has been said that profit is opinion, cash is fact. To avoid companies with potentially aggressive profit recognition, accounting gimmicks and to seek out businesses with good working capital management, operating cash flows should ideally exceed net profit in most years.

Balance sheet; and return on capital (“ROC”) – The one financial metric to rule them all

The safest of scenarios from a balance sheet perspective would be a net cash position. Very often, it is not the case and I am not averse to investing in companies with a net debt position. I do not have a thing against net debt on the balance sheet. It is just that the levels have to be reasonable. My general rule of thumb is that it should not exceed 3.5 times normalised free cash flow (adjusted to exclude growth capex).

On other aspects of the balance sheet, it is hard to pinpoint specific measures due to balance sheet items differing from industry to industry. However, one of the more general metrics I assess would be whether inventory and account receivables drastically exceed that of revenue growth. These are usually respective tell-tale signs of excessive inventory build-ups that could translate to impairments from obsolescence; and disproportionate rise in account receivables that could spell bad debt write-offs coming soon.

In the previous section on ‘Income statement and cash flow’, I mentioned the ideal situation of a quality company having rising top and bottom-lines. That condition doesn’t exist in a vacuum. After all, capital is not free. With unlimited capital thrown into a business, almost any business can grow its revenue and spin a favourable-looking set of financials that is low quality in reality.

The key differentiating factor is the capital structure and the efficiency derived from the capital employed. Truly great businesses should have the ability to generate high returns with little or at least, reasonable amounts of capital. In particular, the high quality capital-type should come in the form of retained earnings rather than from debt. Rocketing debt levels that accompany revenue and profit growth are certainly red flags that deserve greater scrutiny.

This brings us to the next point – ROC. One of the quickest filter to screen for quality businesses would probably be high ROC, which is a hybrid metric that utilises income statement and balance sheet figures. The key difference between ROC and return on equity (ROE) is that ROC takes into account the full capital structure, which includes interest bearing liabilities – debt.

ROC performance is usually one of the key metrics I look out for, since over the long run, ROCs have to exceed the business’ cost of capital in order for value to be created.

An example of a great business with the trait of utilising little capital while generating disproportionate cash flows and growth is Moody’s. In the 10-year period from 2005 to 2015, Moody’s generated about US$7.5 billion in total free cash flows as compared to only investing additional capital of merely about US$0.8 billion. In reality, very few businesses in the world can do this. The public knows this and the valuation of such businesses are usually bid up sky-high. However, every once in a while, when uncertainties arise such as in the case of the US government suing Standard & Poor (“S&P”) over its role in being less than honest about the ratings it gave to clients, there could be opportunities to load up on S&P and its counterpart, Moody’s, when the stock price got beat down over fears of astronomical fines they may have to incur.

I typically start to get interested in a business when the ROCs consistently exceed 15% annually. In the most ideal situation, ROCs would have increased over the years and are expected to continue growing. At the very least, ROCs should at least be stable.

The exception that I will make on ROCs being below 15% is when ROCs have been on an uptrend over the past few years. This trend could be a clue that operations are improving. Importantly, it would warrant further work on investigating if the business has an emerging moat. If it is indeed the case, beyond being just an emerging quality business, this could be an opportunity to get in at the ground floor of a business that may be a compounder for a long time to come.

I would usually go a step further and utilise the DuPont analysis to determine if the source of stable, rising or declining ROCs – margins, turnover and/or leverage. The highest quality of the source of rising ROCs would undoubtedly be margin expansion (most sustainable and in part relates to pricing power) and asset turnover (efficiency in managing resource), followed by the usage of leverage to finance its operations which would be the lowest quality of sources.

ROC.PNG

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Trumped

The day before the presidential elections when Trump was declared President-elect of the USA, I went through an internal struggle on whether to hedge my portfolio. A significant portion of my portfolio is denominated in US Dollars (“USD”) and the stocks are listed in the country. I believe that for most of the people residing outside of the US, they would have hoped for Clinton to win the elections. The prevailing view appeared ot be that a Clinton administration would bring about stability to the global markets.

However, hoping versus reality are 2 very different matters, as I found out for myself when Brexit happened. I didn’t think the UK would leave the European Union but it didn’t matter what I thought. The votes spoke for themselves and the British did vote to leave, never mind the current on-going twists and turns with the British government and the courts’ fight over bringing the ‘Leave’ decision to the parliament. Given that I had a fair percentage of investments denominated in British Pounds (“GBP”), I was caught with my pants down when the value of the GBP dropped against other major currencies. Needless to say, I did not hedge my positions prior to Brexit and had to watch my stock positions in the UK and my excess cash held in GBP, crumble. The good news was that my largest GBP-denominated position was YouGov. As a large portion of YouGov’s business were derived from outside of the UK, coupled with good financial results during the subsequent quarter, the rise in its stock price more made up the currency devaluation over time. This was definitely attributable to good luck, with zero skill involved.

This time around with the potential prospect of Trump being the 45th President of the United States, I converted my remaining excess cash denominated in USD into my local currency to avoid the same from happening again. I hedged a portion of my USD and US stock exposure by buying a gold instrument. This is the first time I have ever bought anything that is closely related to gold, largely because I am in Warren Buffett’s camp – in that he says gold by itself doesn’t produce cash flow and doesn’t have intrinsic merit. I agree with him that over the long-term, gold can’t compound value the way businesses can. I very much doubt he owns gold or its derivatives. However, where I take different approach and depart from this, is that I believe gold can be a good protector of constant value over the short-to-medium-term, particularly in times of uncertainty, such as these Brexit and Trump-entering-the-White-House events. As such, I will only utilise gold in my portfolio very sparingly an in rare occasions.

Anyhow, the US market (both stock and currency) did not react as violent as I or most other people thought. In fact, the S&P ended up a 1.11% higher on 9 Nov 2016 and most of my US-listed stocks turned out OK. The very next day, Asia markets rebounded strongly, with the largest gain coming from Japan, where the Nikkei 225 rose 6.72% and Nippon Paint (a stock I own) jumping 8.73%. To be fair, the Nikkei 225 was also among the largest losers the previous day. Thus, the strong rebound was pretty much a catch-up. With gold price coming off in the past day, I am a couple of percentage points down on my hedge while on a portfolio basis, the cost is less than half a percentage point. I still think the insurance was absolutely necessary. Although it ultimately wasn’t necessary in the end, it served its purpose well and helped me get through the day with much less worries.

As to why the markets reacted the way it did, I think a friend summed it up well:

“I think there is a difference between Brexit and US elections, and hence a difference in market reaction. Brexit is directly an economic event (Britain leaving an economic bloc).

US elections is largely a political event, although it can have economic consequences (which are still unknown as of now)”

Grabbing life by the horns

“Remembering that I’ll be dead soon is the most important tool I’ve ever encountered to help me make the big choices in life. Because almost everything – all external expectations, all pride, all fear of embarrassment or failure – these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart.” – Steve Jobs

Alice Schroeder’s Reddit Ask Me Anything thread

I had the good fortune of stumbling upon Old School Value’s Facebook post on Alice Schroeder’s Reddit Ask Me Anything (AMA) thread. For the uninitiated, Alice Schroeder is the author of the wonderful book – The Snowball – on Warren Buffett.

Though the thread is more than 2 years old, it doesn’t discount the fact that it is a treasure trove of insights from the woman who spent many years understanding his methods and profiling him. It’s probably the next best thing to hearing from the man himself.

Culled some interesting points from the thread for future reference.

  • On how Buffett does his famous back of envelope calculations:
  • Schroeder on a cheap opportunity being a catalyst by itself and on her mistake of anchoring her desired buy price:
  • On Schroeder’s book recommendations:
  • Schroeder on not tying oneself to a single investment approach:
  • On looking forward to life:
  • Schroeder on how to get ideas to start a business (in relation to having understanding disruption and having a sense of how the future looks):
  • Schroeder on assessing B2B businesses’ competitive advantages:
  • On the differences between how Buffett filters opportunities then and now: