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Wednesday, February 5, 2020

Quality Investing kcchongnz

Author: kcchongnz | Publish date: Tue, 4 Feb 2020, 11:48 PM




Why quality companies?

I happened to discover a random portfolio of 8 quality Bursa stocks in an internet forum recently. This portfolio consists of high quality big-caps stocks which are followed closely by fund managers and institutional investors. The stocks are; Petronas Dagangan, Nestle, Public Bank, Dutch Lady, Heineken Malaysia, LPI, Aeon Credit, and Carlsberg.

The portfolio returned an average of 362% over 10 and a half years as on 4th January 2019 as compared to the return of the broad index of 52% during the same period. The compounded annual return, CAR of the portfolio was a whopping 15.7%, close to 4 times the CAR of 4.1% of the broad index.

RM100,000 invested in this portfolio of stocks with equal weighting multiplied to RM462,000 in 10 and a half year, 3 times more than the RM152,000 of a portfolio invested in the 30 component stocks during the same period.

But how do we define a high-quality company?

Ask professional investors what they take value investing to mean, and responses will likely be consistent; buying stocks at low Price/Earnings, Price/Book, Price/Cash flows, high dividend yield etc. But ask the same people what they think of a high-quality company is, and responses will vary widely. Some refer to company having a high growth potential, good management, brand names, market leader of the industry, etc. Beyond these themes, interpretations greatly diverge.

In general, there are three attributes of a high-quality company or business: strong and predictable cash generation; sustainably high returns on capital; and high growth opportunities. Each of these financial traits is attractive at its own right, and when they are combined, they are extremely 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.

Some of the business models which have the above characteristics include;
makers of short-lived products with well-known brand names (Coca-Cola, Carlsberg, Nestle, Gillette)
providers of service/products that always must be/are purchased (pharma, utilities, toll roads)
companies whose products are sold at a distinct premium due to brand name, image, technology or quality (iPhone, Tiffany & Co)
providers of products that are in demand due to external influences and regulations (Rosenbauer International, GEICO)
businesses that have a high level of scalability, i.e. whose marginal cost is close to zero (Microsoft, Goggle, Facebook, Oracle, Pfizer, Netflix, Alibaba, Tencent)
providers of the cheapest product in the market (Wal-Mart, Amazon.com).

Short-lived products with well-known brand names

Some well-known brand names in consumer products use these characteristics and achieve high profitability, return on capital and high free cash flows. Beer drinkers go to the pubs or coffee shops to drink beer and socialize a few times in a week through the nights. Everyday jugs, mugs and bottles of beer are consumed, and stocks of beer or stout replenished. In Malaysia, Carlsberg and Heineken, the only two listed beer companies, grow their business every year, albeit slowly, with strong and predictable cash generation and high return on capitals.

When Gillette sells a razor, the customer has to keep buying new, fitting razor blades every month. With the sale of a razor the business secures itself additional, recurring revenues.

Nestlé carries a strong brand name in the food and beverage market. Given the popularity of its products, it is extremely difficult for new market entrants to grab its market share. It has used this brand-name to further its advantage with short-life products with the introduction of its Nespresso division: the coffee machine is sold relatively cheaply, but the matching capsules can only be purchased via Nespresso. Every sold coffee machine guarantees more capsule sales for the business. In the past ten years Nestlé has sold tens of billions of coffee capsules. As a result, manufacturers of short-lived products are an attractive investment.

The counterexample is the market for long-lived products. Consumers of cars, television, refrigerator, dish washer etc. which consumers rarely need more than one unit of these products.

Products that always have to be/are purchased

Gloves are widely used in the developed world as the first line barrier and it is a necessity to ensure the protection of healthcare industry users in carrying out their daily work. The recent Coronavirus issue has shown the high and continued demand of the usage of gloves. With the improvement and stringent healthcare standards around the world, the demand and usage of gloves in protecting humans is a continuous effort.

Top Glove, the largest producer of gloves in the world, produces nearly a quarter (23 percent) of the world’s demand for rubber gloves, including latex gloves used for medical examinations and surgery. It is a healthy business given that the world uses 150 billion gloves per annum primarily in the healthcare and food services industries. Its vision is to strive to be the world’s leading manufacturer with excellent quality glove products and services that enrich and protect human lives”.

Top Glove Group has been pretty recession-proof, because protective latex gloves are necessities, particularly in healthcare and food services. This ensures its high growth potential.

Similarly, the advantage of another leader in this industry, Hartalega, which has had excellent cash flows and return on capitals, should have a great future enhanced by the good growth potential. Hartalega, which is the largest nitrile glove maker in the world, has the lowest cost structure compared with its competitors. In additional to economies of scale, Harta also continuously innovate production technology.

Utilities are another defensive sector in general. However, a distinction has to be drawn between more cyclical and less cyclical utilities. Electricity providers, for example, can turn out to be quite cyclical if large shares of their customer base consist of energy-intensive manufacturing companies, which will decrease their demand during downturns. The case of the bankruptcy of Hyflux in Singapore is a good example. However, the demand of household electricity is resilient, and hence the stability of earnings of household electricity supply by Tenaga.

Companies with premium products due to brand name, image, technology or quality

Buying luxurious and expensive things is a means for people to communicate their social status to others, a mean of “wealth signalling”. Wealthy women especially like purchasing designer jewelleries, quality Hermes Birkin handbags and expensive shoes for them to express their style, boost self-esteem, or even signal status, or giving a signal “Don’t steal my husband”. Some wives of world leaders have millions and even billions worth of these stuffs hidden in their closets. It seems humans will always want something that others don’t have.

Manufacturers of luxury goods such as Swatch Group (Omega, Longines, Rado, etc.) or the American jeweller Tiffany & Co., Ferrari car manufacturer can command higher prices, and hence the return on capitals. Thanks to their image and product quality.

Products that are in demand due to external influences and regulations

Credit rating agency (CRA), Moody derives its revenues from fees on issuing credit ratings mainly on fixed income, or bond issues. In the United States and Europe, together with S&P and Fitch, they issue more than 90% of all ratings outstanding.

A company raising a bond would usually head to a CRA to get its new bond rated. Institutional investors and retail investors alike with strict investment mandates would be prohibited to buy unrated bonds. This dynamic creates a cycle of demand for a rating by a Moody or other CRAs.

CRAs wield enormous power in which a ratings downgrade can sometimes cause market disruption and capital flight. Any downgrading of company or sovereign debts would result in escalation of borrowing costs of the company of the country.

American car insurer GEICO fits into this category as well. According to law, every driver in the US is obliged to take out at least one car insurance. GEICO quickly developed into a highly profitable car insurer by initially concluding contracts by phone and without a salesperson, exclusively with military officers, i.e. customers who have statistically low accident rates. Berkshire Hathaway owns a major stake in GEICO which has produced huge amount of free cash flows for Warren Buffett to invest in other businesses.

Glove companies are also presented with this advantage due to health requirements.

Products with a high scalability, i.e. marginal costs are close to zero

Successful business growth depends on a scalable business model that will increase profits over time, by growing revenue while avoiding cost increases. Scalability is what makes a business, in the simplest terms, big, and which typically means greater revenue streams; combine this with efficiencies created by economies of scale, and therefore lower costs, until the marginal cost of producing one additional unit of that product is equal to the marginal revenue, they will receive from selling that additional unit of its product, and you have a recipe for a profitable business with strong growth potential.

In economic terms, a firm is maximizing its profits when marginal revenue = marginal cost.

For industrial products made in a factory, there are additional costs that are incurred for producing more of your product. If you were to double production, you would need to hire more labour, invest in more machinery, buy a bigger warehouse etc. If the price of the product you sell is not increasing, it won’t be long before the marginal cost catches up to the marginal revenue.

For a digital company like Netflix, the cost of selling one additional membership is close to $0. They don't need a bigger factory or hire additional labour to “produce” one additional membership. Put simply, Netflix has a product that is completely scalable. Scalability allows a company to meet the demand of consumers in almost every situation.

Investors love a business that has scalability because they believe that as a company grows its revenues over time it will also increase its profits, and hence its return on capitals. As a result, Netflix stock price has increased by more than 37,000% since the company went public in 2002.

For many software companies, SAP and Oracle, once developed, the product can be duplicated without additional cost. Similarly, high returns can be found at Microsoft, with its operating systems and office applications. Producers of pharmaceuticals such as Novartis. Pfizer and Merck also fall into this category. There are high initial costs for research and development, but these are recouped in low costs per pill once the product is successfully introduced into the market.

The cheapest product in a market

Besides providing quality products at a premium, being the cheapest product in the market can also constitute a unique selling point. With this strategy, the objective is to become the lowest-cost producer in the industry. This strategy is usually associated with large-scale businesses offering “standard” products with relatively little differentiation that are perfectly acceptable to most customers. Occasionally, a low-cost leader will also discount its product to maximise sales, particularly if it has a significant cost advantage over the competition and, in doing so, it can further increase its market share. In an economic or financial crisis, low cost producers tend to survive better than its high cost peers which could face bankruptcy, and the surviving low-cost producers taking their shares subsequently.

However, often a pure price war results in shrinking margins for low cost producers. It is more important in maintaining an acceptable quality and low prices at the same time. An example of such an exceptional case is Amazon. Through a sophisticated logistics network, comparatively good customer service and sheer size, the online retailer has a cost advantage against its competitors.

Wal-Mart, through its gigantic sales volume of more than $400bn, Wal-Mart achieves the highest purchasing volume worldwide and thus secures itself pricing advantages and bargaining power. It practically doesn’t require any working capitals to run its huge business. This provides the business with high return on capitals and abundant free cash flows to grow its business.

Valuation of quality companies

In quality investing, as in any investment strategy, the risk of overpayment exists, but far less than one might think. At a glance, the price-earnings multiples of a quality business relative to its growth can look exaggerated. However, quality companies often tend to exceed estimates, meeting or beating forecasts far more frequently than poor quality companies.

For most people, it is better to invest in quality companies for long-term. But that doesn’t mean one should pay any price for a quality company. That is suicidal in investing, in fact, in any kind of investing.

But what price should one pay for a quality company? We will discuss about this next.

For those who are interested to learn more about how to identify a quality company and what a fair price is may contact me for a eBook written by me at

ckc13invest@gmail.com

It is free.

KC Chong

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