Buying a high-quality company

What makes for a high-quality company? Our definition of a high-quality company is one which has the following characteristics:

We like to invest in businesses that are highly profitable, when measured on Return on Equity.

Return on Equity = Net Profit / Shareholders’ Funds

Return on equity is the engine of growth of a business. Ideally, this profitability should be consistent over time. Profitable companies are able to set aside funds to reinvest in the business and drive future growth without taking on debt. They may also return a part of the profits to their shareholders as dividends or buybacks. Growth without profitability only destroys value over the long term.

The Intrinsic Value of a business is the sum total of all free cash flows that can be derived from the business till eternity, discounted back to today at an appropriate discount rate. Investors use different discount rates to measure this, but at the minimum, the discount rate is the risk-free rate (rate of interest on long term government bonds).

From this, we can conclude that any business earning a return on capital employed less than the risk-free rate, over the long term, will see its intrinsic value decline over time. In fact, any business earning a return on capital employed lower than its cost of borrowings would destroy value over the long term. Hence, the return on equity and the return on capital employed, over the long term, are key ratios we look at when we invest in a company. For us, growth with profitability is valuable – even very high growth without the prospect of profitability is not something we are comfortable with.

The business should generate cash on a consistent basis. This should be evidenced as cash, sitting on the balance sheet, or at the minimum, a very low Debt-to- Equity Ratio. Often, people focus too much on the Profit and Loss statement of a company; we believe the Cash Flow statement is more important. There are several companies which earn net profits, but they may also have high capex and working capital requirements, which means the company is not making free cash flows.

This harks back to the principle of safety that we mentioned in ‘Goals of an Investor’. High debt is the leading cause of bankruptcy the world over. By investing in companies that generate consistent free cash flow, we can avoid permanent loss of capital in the businesses that we invest in.

For profitability to sustain over the long term, the company must have a competitive edge over its peers. This competitive edge can come in different forms:

1. Lowest cost producer of a product or service – companies that have economies of scale. A lower cost of production would result in higher profitability in a competitive market.
2. Technological Edge – the company may hold patents or have a superior product or process which allows for a technological edge over its competition.
3. Brands: Brands typically have an emotional connect with the customer and companies that own brands which allow them to charge a premium over the competition have a strong competitive edge. Strong brands typically result in the company having a large market share.
4. Switching Costs: Switching cost is the cost associated with switching from one supplier to another or one brand to the other. These can be monetary, psychological, effort-based or time-based. This hold on the customer can be a source of competitive edge.
5. Network effects: This is a situation in which the value of a product, service or platform grows as the network grows and can impart a competitive edge to a company. For example, a social networking site, or a dominant stock exchange.

While our emphasis is clearly more on profitability than on growth, our target is to find companies which are growing sustainably at least at the nominal GDP growth rate, which is a measure of how the economy as a whole is growing. Ideally, we would like our companies to grow at a higher rate and the sustainable growth rate of the business is a factor while deciding the weights in our portfolio.

One of the tenets of value investing is that while buying a stock, one is not buying a scrap of paper whose value is fluctuating on a daily basis, but one is buying the underlying business. However, we are not running the business – someone else is running it for us and unless the management treats us fairly as minority investors, we can’t expect to benefit from the rest of the thesis outlined above. So corporate governance is of great importance to us while selecting stocks. Not only should the management be honest, but it should also be competent.