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11 Nov 2016

WHAT MAKES A QUALITY COMPANY

As with the concept of beauty being in the eye of the beholder, so might the concept of quality be in the eye of the analyst. In other words, the notion of a quality company means different things to different people. Equity analyst, IRINA SCHULENBURG, looks at Foord’s definition of a quality business and why this is important for the long-term investor.

Warren Buffett said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Provided you don't overpay,1 wonderful companies will compound your wealth at above average rates year after year.

At Foord, we refer to Buffett's wonderful companies as "quality companies." But what are these companies and what qualities make them so wonderful? Broadly speaking, quality companies possess sustainable competitive advantages that allow them to earn returns well above their cost of capital. They also all exhibit distinct degrees of excellence relative to their competitors.

Michael Porter developed a "five forces" model to analyse the competitive forces within an industry. These factors, namely industry rivalry, bargaining power of suppliers and of buyers and the threats of new entrants and substitutes, can be applied to a company to determine its relative positioning. In addition to these, we examine five additional business-specific attributes to assess a company's quality:

  1. Management should be competent and well qualified. We recognise that because people run businesses, management is paramount to the company's strategy, culture and ultimate success. Meritocratic ownership cultures and well-structured cash-based incentive programmes help to deliver long-term shareholder value, with the lowest possible risk.
  2. Quality businesses stay focused. It takes years to build a company and its brands, but goodwill can dissipate quickly if management loses focus on client needs, gets distracted by market fads and lets costs balloon. An obsessive focus on their value propositions and cost control translates over time into higher revenue, higher profitability, greater capital velocity and correspondingly better returns on invested capital.
  3. Leadership sustains momentum with a proud vision. This aspect is key to retaining talented, creative people. To avoid stagnation, quality companies maintain momentum by making small or sometimes large corrections to their strategic direction. Timing strategic change depends on close attention to consumer demand. Change for the sake of change serves only to destroy brands.
  4. Quality companies generate strong free cash flows. Cash is oxygen to a business: You never appreciate how much you really need it until you don't have it. Cash flow is essential to on-going investment as well as to dividend payouts.
  5. A strong and disciplined board of directors can be a powerful strategic asset. Good corporate governance ensures that the allure of potential growth does not blind management to common sense and downside risk. It is essential in maintaining balance between the interests of management and minority shareholders.

All quality businesses display these attributes. Identifying a quality business is important because we know that they grow their earnings over the long term at a rate faster than the market as a whole.

Since company share prices ultimately track their underlying earnings' growth, investing in quality companies establishes a good basis for the above-average long-term growth of investors' capital.

1 Note Buffett did not say "any" price – overpaying for an asset will severely limit future returns.

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