We are active investors. We’re all analysts and each of us is charged with identifying good-quality companies to invest in for the long term.
For us, assessing quality is a highly subjective activity. We don’t go about it by ticking boxes on a sheet, drawing up sets of screening criteria or plugging numbers into computer programs. On the whole we believe these things can hide as much as they reveal.
But our approach is nonetheless methodical, and after rigorous investigation by members of the team – in a role that could best be described as part analyst, part historian and part detective – we form a view of a company’s quality and valuation that allows us to feel comfortable about whether or not to invest for the long term.
Our process means that we analyse many more companies than we invest in, given our high quality requirements. But we don’t consider our efforts to be wasted: the process helps us to learn continuously and to evolve our understanding of true quality, owing to the many examples we come across where it is absent.
Finding quality companies
We would love to be able to say we have constructed a clever algorithm so that a black box tells us which ten companies to consider each week, but we haven’t. In reality, we start with a blank sheet of paper, and instead of whittling down 65,000 to 50; actually we are starting from 0 and building up to 50. One analogy that we have used is the idea of walking along a beach looking for 50 of our favourite shells. We know what we are looking for in our collection, but we won’t be looking at every shell on the beach to find them. And we are likely to spot new shells each day we go and will continue to do so for years to come. Such is the task of operating in a universe of 65,000 companies.
What we mean by quality
We judge quality in three key areas:
Quality of management
The stewardship of a company is a fundamental element in our assessment of quality. We understand that we’re using our clients’ money to buy, not a series of numbers on a screen, but rather a share of a living, breathing entity run by and for people.
One of the advantages of long-term investing is that there’s a relationship between the returns we might expect and the track record of competence and integrity of the people in charge – the stewards. We’re ever mindful that the quickest way to lose money is to invest alongside the wrong people.
There’s no point in having a management team who are astute but who are likely to steal from shareholders, or indeed people who are honest but not up to the job. What is their attitude to their employees or the communities where they operate? Do they take unnecessary risks?
Furthermore, can they develop and put in place strategies for sustainable predictable growth? Are they nimble and innovative enough to cope when things go wrong? Do they take short cuts by underpaying taxes or taking on too much debt? Are they good long-term allocators of capital?
To us, sustainability and environmental, social and governance (ESG) issues are key considerations when assessing the quality of management, as are the ethical conduct and integrity of stewards.
One outcome of this has been that we tend to favour family-controlled businesses that have been passed from generation to generation. While there are many examples of family-controlled companies that do not treat other stakeholders (including minority shareholders) well, we want to invest alongside owners who share our goal of value creation over the long term.
Quality of the franchise
By franchise, we mean the economics of the company’s business model, which includes elements like brand and market share, pricing power and competitive advantage.
We are attracted to companies with business models we believe will generate sustainably high returns on capital. Whilst barriers to entry are a part of this it also involves thinking about companies whose products and services generate mutually beneficial outcomes for customers, employees and other stakeholders.
As investors on behalf of our clients, we are ultimately interested in finding companies that can convert their profits into cash flow, and many of the companies we find ourselves attracted to show highly predictable patterns of cash flow generation.
We are looking for businesses that can be profitably scaled up over the longer term, and so developing a view on a company’s growth opportunities is another integral part of our process.
Sustainability insights also help us to think about franchise. Companies who profit by harming people or the environment are always at risk of having those profits taken away when the backlash inevitably arrives, whereas those that support sustainable development and provide a range of benefits to society are more likely to see demand for their products grow.
Hence we consider companies selling products with high levels of sugar, salt and fat to have a weaker franchise than those selling healthier foods, or consumer staples like toothpaste and soap. Because the former are contributing to poor health outcomes, they’re likely to face greater sustainability headwinds in the form of negative attention from public policymakers.
Quality of the financials
Our approach to a company’s financial situation is conservative. This is not to say that we don’t invest in strongly growing businesses, but rather that we like businesses that can also weather the storms when they come. They should have strong, resilient cash flows and reserves.
We want companies that have stood the test of time, so we delve into their performance over a number of economic cycles to build a full picture. How did they fare in a period of stagnant growth or during an economic downturn? We’d never be content to make a decision on the current state of profitability alone.
The ability to grow cash flows over the long term is important but we prefer predictable to simply rapid growth, particularly as we appreciate the power of compounding returns for long-term investors. In our experience sustainability issues are often parked in the race for growth, hence we prefer the marathon runners to the sprinters.
We also assess the quality of accounting and the financial statements themselves, as we’re only too aware these can be manipulated. We investigate everything from the reputation of the audit firm to unusual changes in financial year ends and aggressive accounting policies. Are they spending a lot of time trying to avoid tax? We’ve uncovered many a corner-cutting risk-taker in this way.
Companies that meet our criteria are included in our focus list. There are usually around 300 companies on this list and it’s evolving all the time as we refine our views on companies and build conviction.
Our judgment of quality is heavily influenced by our thinking with regard to the challenges of sustainable development.
We recognise and support the need for societies to maintain a sustainable ecological footprint as they develop. Furthermore, we believe that a company’s ability to contribute to and benefit from helping societies to achieve this – i.e. its sustainability positioning – is a key indicator of its quality.
As a result, sustainable development issues are fully integrated into our consideration of the three pillars of quality: management, franchise and financials.