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How we pick companies
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.
What do we mean by this?
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.
Shells on a beach
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 companies to 50; actually we are starting from 0 and building up to 50. We focus on finding our preferred companies, knowing exactly what qualities we are looking for, without needing to examine every single one. Given the large number of companies available, we will continue to discover new ones regularly.
What we mean by quality
We judge quality in three key areas:
Quality of management
Our clients’ money is not a series of numbers on a screen, but rather a share of a living, breathing entity run by and for people.
The stewardship, or leadership, of a company is a key 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 money we might expect to make on our clients’ behalf 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 clever 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 at managing the business’ finances over the long term?
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 creating value over the long term.
Quality of the franchise
By franchise, we mean the economic aspects of a company’s business model, including brand strength, market share, pricing power, and competitive advantage.
We seek companies with businesses that can deliver consistently high returns on our investments. This includes considering the barriers other companies would face in entering the same market, as well as identifying those whose products and services create positive outcomes for customers, employees, and stakeholders.
Investing on behalf of our clients, we focus on finding companies that can convert their profits they earn and turn them into actual cash that can be used for various purposes, such as reinvesting in the business. We prefer companies that consistently generate cash in this manner.
We are looking for businesses that can grow profitably over the long term. This helps us develop a view on a company’s growth opportunities.
Our approach to sustainable development also helps us to think about the business franchise. Companies who profit by harming people or the environment risk losing these profits, whereas those that support sustainable development and provide a range of benefits to society are more likely to see demand for their products.
For example, we view companies selling high-sugar, high-salt, and high-fat products as having a weaker franchise compared to those offering healthier options or essential goods like toothpaste and soap. The former face greater sustainability risks due to potential negative attention from policymakers related to public health outcomes.
Companies that support sustainable development and provide a range of benefits to society are more likely to see demand for their products grow.
Quality of the financials
In our experience sustainability issues are often parked in the race for growth, hence we prefer the marathon runners to the sprinters.
Our approach to a company’s financial situation means that we don't take excessive risks. This doesn't mean that we don’t invest in strongly growing businesses, but we prefer businesses that can also weather the storms when they come. They should have strong, resilient cash flows and savings.
We want companies that have stood the test of time, so we delve into their performance over several years to build a complete picture. How did they fare during periods of no growth or economic downturns? We never base our decisions solely on current profits.
While the ability to grow over the long term is important, we prefer predictable growth to rapid growth. We understand the long-term power of compounding (i.e. the ability to earn interest on interest, or returns on returns) and its benefits for investors. In our experience, sustainability issues can often be overlooked in the pursuit of rapid growth, so we prefer companies that can grow steadily over time rather than those that expand too quickly.
We also assess the quality of accounting and the financial statements themselves - because these can be manipulated. We investigate everything from the reputation of the audit firm to unusual changes in financial dates and aggressive accounting policies. Are they spending a lot of effort avoiding taxes? We have uncovered many risk-takers cutting corners 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 our belief in the companies on our list.
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.
