Quality Investing, Lawrence Cunningham (10/10)
A short, sweet and engaging book that aims to institutionalise the lessons learned from refining AKO Capital’s quality-focused investment philosophy
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Quality Investing is a short, sweet and engaging book that aims to institutionalise the lessons learned from refining AKO Capital’s quality-focused investment philosophy.
According to AKO, 3 characteristics indicate quality:
- Strong, predictable cash generation
- Sustainably high returns on capital
- Attractive growth opportunities
Each of these financial traits is attractive in its own right but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.
Moreover, the 4 most significant challenges in quality investing are:
- Battling short-term thinking
- Conquering prevailing preferences for ‘hard’ numerical data over subjective assessments of quality
- Accepting that quality companies are not always the most exciting investments
- Accepting that quality stocks will often appear to be expensive.
The book thoroughly outlines the attributes of quality companies and the challenges of investing within this framework.
🔍 How I Discovered It
Maxim, a friend and one of the TCF interns, recommended that I read it.
🥰 Who Would Like It?
The authors draw on several entertaining examples of companies and industries to illustrate their arguments, and I would highly recommend this book to anyone interested in entrepreneurship, business, finance and investing.
✍️ My Top 3 Quotes
- We are averse to ‘scale for scale’s sake’, particularly when managerial bonuses are paid based on metrics linked to corporate size, such as absolute revenue or profit growth.
- Three elements drive corporate cash return on investment: asset turns, profit margins and cash conversion.
- The best businesses to own are those in which end markets are growing rather than shrinking.
📒 Summary + Notes
When M&A Makes Sense
Acquisitions are a common source of value destruction, so it's usually better for capital to be deployed on organic growth as opposed to M&A. That said, there are a few contexts in which acquisitions can create value for shareholders.
Consolidation of fragmented industries is often an appealing rationale for growth through acquisitions. While such roll-ups don't invariably succeed, there are notable examples of successes.
- Small bolt-on acquisitions where your business adds significant value
- Buying businesses that are already strong
- Leveraging network benefits - such as a larger or more comprehensive distribution network
Acquisitions are risky.
Managers do not always provide investors with sufficient information to evaluate proposed M&A completely or objectively.
Red flags such as diversification, scale and rapidity often accompany ill-fated acquisitions.
We are averse to ‘scale for scale’s sake’, particularly when managerial bonuses are paid based on metrics linked to corporate size, such as absolute revenue or profit growth. And we become concerned when a company completes multiple large acquisitions in a relatively short time frame. This would always lead us to probe whether the deal-making is a response to deterioration of the underlying business.
Dividends & Buybacks
Excess cash should be distributed to shareholders as dividends or share buy-backs.
Too often, companies repurchase excessively during periods of economic expansion, when stock prices are high, and insufficiently during economic downturns, when prices are low.
The Costs of Working Capital
While inventory and receivables eventually turn into cash, until then they're tied up in the production and sale process.
A company’s overall working capital burden often reflects its bargaining power with other stakeholders: those positioned to dictate terms typically enjoy more attractive working capital profiles.
For companies that grow, associated costs of working capital rise. Growth means more money is stuck in transit as inventory or unpaid bills.
The incremental working capital required for growth is critical as it reduces cash flow growth, and hence the company’s value creation.
Those best-positioned to mitigate the money drain are those able to produce at low costs (less cash tied up as inventory) or to operate with rapid inventory and receivables turnover.
Returns on Capital
Return-on-capital metrics measure the effectiveness of a company’s capital allocation decisions and are also arguably the best shorthand expression of its industrial positioning and competitive advantages.
Three elements drive corporate cash return on investment: asset turns, profit margins and cash conversion. Asset turns measure how efficiently a company generates sales from additional assets, which can vary greatly depending on the asset intensity of the industry itself; margins reflect the benefits of those incremental sales; and cash conversion reflects a company’s working capital intensity and the conservatism of its accounting policies.
The simplest and most commonly used tool for measuring returns is return on equity: net income as a percentage of shareholders’ equity. While useful as a general proxy, the figure is crude for two reasons.
- The return part of the equation uses accounting measures, whose application leaves managers with considerable discretion over the treatment of important measures such as depreciation and provisioning.
- The calculation can also be distorted by factors that affect the value of shareholders’ equity, such as write-downs and debt levels.
Return measures should illuminate the cash return from each dollar invested by a business, irrespective of capital structure and accounting techniques.
Measures such as return on invested capital (measured as net after-tax operating profit divided by invested capital) go some way towards achieving this.
Better yet is a metric zeroing in on cash returns on cash capital invested (CROCCI); this is measured as after-tax cash earnings divided by capital invested after adjusting for accounting conventions such as amortisation of goodwill. CROCCI measures the post-tax cash return on all capital a company has deployed.
Although gross margin is a partial function of a company’s industry and high gross margins can reflect low asset intensity, sustained high gross profit margins relative to industry peers tends to indicate durable competitive advantage.
Focussing on gross margins, as opposed to bottom line net income, also helps distinguish competitive advantage from managerial ability: bloated but short-term cost structures can reduce net income and disguise real long-term competitive advantages.
High gross margins also confer other advantages: they can expand the scope for operating leverage, provide a buffer against rising raw material prices and provide the flexibility to drive growth through R&D or advertising and promotion.
The more incremental top-line revenue that ends up as bottom-line profit, the better. Suppose two rivals each grow revenue by a dollar. If it costs one of them ten cents to do so and the other 80 cents, the growth is clearly more valuable for the former.
Multiple Sources of Growth
The best businesses to own are those in which end markets are growing rather than shrinking.
Opportunities for growth maximize the benefits derived from high returns on capital. Such opportunities can arise from market growth, either cyclical or structural, or through a firm grabbing share from rivals in existing markets or expanding geographically. The very best companies enjoy a diversified set of growth drivers through ingenuity in the design of products, pricing, and product mix.
A. Gaining Market Share
- Growth through gaining market share has two things in its favour. First, it is independent of the economic climate – share gains can occur in good times and bad. Second, it is something over which the company itself has a degree of control.
- When analysing share gains, understanding the source is important. Market shares in some industries fluctuate dramatically depending on relative pricing strategies and product innovations of participants. Market share gains represent the best pathway for growth if they happen in a consistent way and, ideally, in a market where the investor can identify a reliable share donator.
B. Geographic Expansion
- Geographic expansion is one of the most challenging strategies for businesses to implement.
- Companies that rely on unique business structures for competitive advantage at home will face the greatest difficulty expanding geographically.
- Conversely, certain types of competitive advantages travel better to new places than others. Thanks to the globalisation of travel and media, premium brands transition relatively easily into new markets.
- Manufacturers operating their own stores enjoy a particular advantage, as their vertical integration makes them less reliant on a country’s infrastructure.
Pricing, Mix and Volume
Viewed from a purely financial perspective, growth in revenue can be broken down into price, product mix, and volume. Setting inflation aside, companies able to increase prices without corresponding increases in cost (or reduction in unit volume) have substantial pricing power.
Mix-driven growth is highly valuable, entailing limited capital expenditure and only modest increases in working capital. But it is inferior to pure price-driven growth because it usually requires some increase in production costs.
In purely financial terms, volume-based growth is the least valuable, since it entails increasing quantity at existing average unit prices. Incremental revenue from volume increases tends to have a minor impact on gross margin.
Volume growth is particularly valuable for asset-light businesses boasting high margins and those with high operating leverage, such as pharmaceutical or software companies.
Structural End-Market Growth
Many emerging market trends previously considered structural seem, in hindsight, to have been more cyclical in nature.
Despite this, there are a number of long-term trends that are more likely to prove sustainable than others, ranging from disease prevention to urbanization and aging demographics in developed markets.
- Disciplined Stewards: Good managers have the patience and discipline to invest in organic growth and the willpower to resist the temptation of a dash for growth through ‘transformational’ (and often value-destructive) acquisitions.
- Independent, Long-Term and Tenacious
- Out Of The Limelight
- People Matter: Good management recognizes that a top priority is developing and deploying people who will then help achieve an organization’s goals.
- Candor: Good management extends beyond internal execution to outside constituents. From the investing perspective, that means effectively communicating to investors what is important and why. It also means being candid and speaking in a straightforward professional manner rather than indulging in the elliptical spin politicians favor.
Over time some industries lend themselves to sustainable high returns for all players, even amid competition.
The best industries are those where all companies can afford to think long term. If an industry’s technologies, demand and participants will remain constant, it reduces the incentive to attempt to increase earnings in the short run at the expense of the long.
The products of quality companies confer considerable benefits on their customers and understanding the relative value of these benefits is an important part of business analysis. We focus on a few types of benefits most likely to differentiate a product or service in a way that yields superior economics. After introducing each – intangible benefits, assurance benefits and convenience benefits – we consider how different customer types respond to them.
- Intangible Benefits
- Assurance Benefits
- Convenience Benefits: Simply making a product readily accessible is an easy way to provide a clear benefit to customers.
- Customer Types: Customers are diverse but it pays to distinguish between two broad groups: retail consumers and corporate clients.
We highlight three aspects of the subject to set the stage: technology, network effects, and distribution advantages.
- Technology: Technology is only a sustainable competitive advantage if it helps make products that deliver superior customer benefits over long periods of time.
The desired outcome is always clear: strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities.
Friendly Middlemen / The Helping Hand
Among a company’s more valuable middlemen are those that bundle delivery of the company’s product with their own expert services. In one such type of bundling, the middleman is both a salesman and an expert, say a dentist recommending an implant or even a brand of toothpaste.
Being well-known is only one part of the equation. Successful brands also offer something differentiated, whether product, design, or image. Winning brands create an affinity, an attachment with the customer, either emotional or logical. For want of a better word, they are loved.
Forward integration can also ease entry into new markets. Companies that control their own stores and infrastructure depend less on the kindness of strangers to promote the company’s benefits. Dependence on partners or other companies in supply chains can prove particularly tricky in emerging markets, where verifying reliability can be difficult. In our view, companies that take the time to build their own operations from scratch are more likely to succeed than those who are at the mercy of third parties.
Successful franchising models generally have two characteristics. First, the underlying business needs powerful economics: strong enough for a third party to make an attractive return even after paying a fee to the brand owner. Second, there is a minimum scale requirement: the company must have the infrastructure to support a franchise system and the financial firepower to support a brand with A&P.
In quality investing, the four most significant challenges are:
- battling short-term thinking;
- conquering prevailing preferences for ‘hard’ numerical data over subjective assessments of quality;
- accepting that quality companies are not always the most exciting investments; and
- accepting that quality stocks will often appear to be expensive.
Mistakes are inevitable in investing but can be reduced by tools consciously designed to combat their sources as well as refined reflection on past mistakes and current biases. Checklists can help focus rationality and confront the important questions about an investment. Given the complexities, no checklist can capture every nuance or draw attention to every risk. However, using them can facilitate adherence to the principles of quality investing and highlight extraneous top-down factors that may tempt an investment decision, such as stellar short-term growth or an optically low valuation.
A good checklist should enumerate all the desired attributes for an investment and, ideally, the steps required for full due diligence. It should also incorporate lessons learned from previous mistakes and be regularly updated accordingly.
A primary technique for mitigating the influence of biases is to focus as far as possible on the process rather than the outcome: adhering to fundamental investment principles in the face of inevitable market gyrations.