What do we mean by a quality company?Download document (206 kB)
As part of our investment philosophy we say that we invest in quality companies. We develop this further by saying we invest in companies with sound financials, strong franchises and responsible stewardship. What do we actually mean by this?
There is no such thing as a perfect company.
All companies change over time and quality is about a journey; a direction of travel.
What is a Quality Company?
The diagram above tries to explain our approach to quality, suggesting that quality is made up of objective factors (e.g. working capital numbers or a company’s historical record), as well as subjective ones (e.g. owners/management integrity or attitude to risk).
The attributes listed within each circle are not necessarily the most important elements of quality, but simply indicate that there are many different aspects to quality.
The size of each circle, however, is significant and reflects the relative importance of each category to us. We have always emphasised that quality of stewardship is the most important ingredient of quality. Assessing stewardship quality is not always easy; it is subjective and exhibited in a number of ways, as indicated in the diagram above and related appendices. We rarely find responsible stewards directing companies with overstretched balance sheets or with deteriorating franchises for other than a short time period.
Quality should be regarded as fluid and multi-faceted
Our approach to quality is not driven by lists or box-ticking. We believe that quality is not set in stone but is a fluid concept. As an investment team, we are always seeking ways of reappraising what quality is, as part of the ongoing debate within the team about which companies we should invest in for clients.
The definition of quality is not the same for all members of the investment team. Individuals on the team emphasise different aspects or characteristics of quality, but all recognise its crucial role in the investment process. Consequently, all of us would consider a very significant proportion of our investment universe as totally uninvestible.
Why do we invest in quality?
We believe that by investing in quality companies we can control risk in businesses which we are not running ourselves and so preserve capital for clients. This is evidenced most clearly by the historic outperformance of our portfolios in extended down markets.
We believe our emphasis on quality is far from universal, although it does seem a more favoured approach now than it was 20 years ago. Many investors focus much more, sometimes exclusively, on quantitative data, often extrapolating recent trends as if they will continue forever. However, it is only common sense that those companies, which are able and willing to eschew short-term profit performance to build solid foundations for sustainable growth, and which look after the interests of all stakeholders, are likely to be long-term investment winners.
In the three appendices that follow, we provide some of the elements of quality we seek in our three ‘pillars’ of Stewardship, Franchises and Financials. When appraising quality, these indicators are by no means exhaustive and we are always looking for new ways of defining and measuring quality.
As an aside, insofar as we can, we try to manage the Stewart Investors business in accordance with the above principles. We also know that we have a very long way to go before becoming that mythical perfect company!
|Adaptability||Management should stick to what they do well, but be adaptable to changing circumstances.|
|Agendas||State-controlled companies in particular often have conflicting agendas, such as maintaining employment regardless of the impact on long-term shareholder returns.|
|Alignment||The interests of management should be aligned with minority shareholders.|
|Associations and partnerships||These are indicative of management quality.|
|Awareness of environmental issues||A focus on Environmental, Social and Governance (ESG) issues reduces risk.|
|Comfort zones||We like managements who are restless, accept that their company is not perfect and seek continual improvement.|
|Consultative autocracy||We like management who consult but are willing to take difficult decisions.|
|Crisis Reaction||We view the openness and effectiveness of a company’s response to an unforeseen problem as an especially good indicator of the underlying corporate culture.|
|Diversity on the board||Different backgrounds in terms of class, ethnicity, gender and experience etc. provide diversity of opinion and reduces the risk of ‘herd mentality’.|
|Dividends||Payment of dividends and dividend growth indicate a culture where management are focused on shareholders, rather than chasing growth for the sake of it or to meet management’s short-term remuneration targets.|
|Family control||We like companies where we are aligned with controlling families who are able to take a long-term view.|
|Incentivisation||Remuneration schemes provide very useful insights into corporate cultures.|
|Independently minded CEO and CFO||Top management who exhibit independence from each other ensure strategy and views are challenged.|
|Integrity||Dishonest owners and managers can destroy the wealth of minority investors far more quickly than generally appreciated. Leopards rarely change their spots.|
|Innovative||We expect management to show evidence of pursuing innovation in running their companies.|
|Learning from mistakes||We find that owners and managers, who are sufficiently humble to acknowledge their errors of commission and omission and are able to sight the lessons they have taken from them, are much less likely to repeat them.|
|Long-term focus||We believe that a focus on the long-term will provide superior returns for investors.|
|Measured approach to growth||Steady sustainable growth is preferred to ‘vaulting ambition’, especially when expanding into new businesses or geographies.|
|Organic growth vs growth by acquisition||We are wary of companies that deliver growth principally by acquisition.|
|Barriers to entry||Make it difficult for competition to enter the industry and reduce margins.|
|Brand strength||Allows maintenance of margins and can boost sales.|
|Competitive cost structures||We prefer companies producing at, or near, the bottom of the cost curve.|
|Favourable supply/demand balance||Too much supply or a lack of demand will undermine pricing and profit margins.|
|Growing market share||We prefer companies which are growing market share and have the potential to be a market leader.|
|High Returns on Equity (ROE)||We prefer high ROE companies, so long as ROE is considered sustainable.|
|Limited competition||Intensive or irrational competition can undermine profitability.|
|Long product cycles||All products have a shelf life. There is rarely any point in owning a company with a product which is in terminal decline.|
|Low cyclicality||Sustainable growth is preferred to cyclical earnings. Predictable cash flow. We favour businesses with predictability of cash flow.|
|Pricing power||We like companies which are able to increase prices with, or above, inflation rather than being ‘price takers’.|
|Stable margins||We like companies which have maintained margins over previous business cycles and are cautious where margins are untypically high.|
|Minimal threats||We seek a low degree of threat from external factors such as China or the internet.|
|Auditors||We often find a change of auditors to be an indicator of financial shenanigans.|
|Balance sheet strength||We regard this as a fundamental measure of financial health.|
|Buy backs||We are wary of share buy backs unless carried out when the share price is at a reasonable level and without recourse to debt.|
|Cash flow||We favour companies which generate plentiful cash, often a much more reliable indicator of performance than reported earnings.|
|Currency mismatch||We are cautious of any mismatch between a company’s revenue stream and the currency in which its debts are denominated.|
|Debt||We like companies which make a conscious effort to reduce their debt levels.|
|Financial complexity||We often find that complicated financial structures/transactions and off-balance-sheet funding arrangements are indicators of detrimental concealment.|
|Offshore exposure||We consider the reasons for obscure headquarter locations and overseas listings worthy of investigation prior to investing.|
|Tax management||We are wary of companies that record exceptionally low rates of tax.|
|Working capital||We are especially cautious about investing in companies recording growth of inventory or receivable days.|