Compounding Quality

Compounding Quality

13-11-2022

13:51

🏆🧵 Quality investing is one of the best investment methods in the world. Since 2010, this investment strategy returned more than 18% (!) per year to shareholders. Learn how to find quality stocks here ⬇️⬇️

What is a quality company? For legendary quality investor Terry Smith, quality investing is based on 3 metrics: 1. Buy good companies 2. Don’t overpay 3. Do nothing Here you can find a thread we recently wrote about Terry’s investment strategy:

Some great examples of quality companies can be found in Terry Smith’s portfolio (Fundsmith):

Chuck Akre’s three-legged stool also offers a great framework for quality investors: 1. Buy good, very profitable businesses with a wide moat 2. With capable and integer management 3. Which can reinvest a lot of free cash flow in organic growth

Chuck Akre is currently invested in beautiful companies like Mastercard, American Tower and O’Reilly Automotive.

The million-dollar question is how to find these quality companies. Quality companies have the following characteristics: - A wide moat - Integer management - Low capital intensity - Good capital allocation - High profitability - Attractive historical growth - A secular trend

Wide moat Over the past decade, wide moat stocks outperformed no-moat stocks with more than 8% (!) per year. You want to invest in clear market leaders with strong pricing power and a great product/service which customers love.

Here you can find all stocks with a wide moat according to Morningstar:

Integer management Companies with skin in the game outperform companies who don’t with 3.6% per year on average. You want to invest in businesses where the interests of management are aligned with yours as a shareholder. Think about companies like LVMH and Copart.

Learn more about skin in the game here:

Low capital intensity The best companies require very little capital to operate. Almost all compounding machines have a low capital intensity. Seek for companies with a CAPEX/Sales < 5% and CAPEX/Operational Cash Flow < 15%.

Some low CAPEX quality businesses: Automatic Data Processing (CAPEX/Sales: 1.2%), Domino’s Pizza (CAPEX/Sales: 2.2%) and Blackrock (CAPEX/Sales: 1.8%).

Good capital allocation When a company earns cash they can do three things with the FCF they generate: - Reinvest for organic growth - Acquisitions (M&A) - Share buybacks and dividends

Seek for companies who reinvest most free cash flow in organic growth.

In general, the greater the capital allocation of a company, the better. Looking at ROIC and ROCE is a good start. We prefer companies with a ROIC greater than 20%.

This visual from @safalniveshak sums it up quite well.

High profitability The free cash flow margin shows the percentage of sales that is translated into cash. When a company has a FCF margin of 30%, for every $100 the company sells, $30 of cash is generated.

The FCF margin of a company should be at least 15% (and preferably more than 20%). Furthermore, a high percentage (> 90%) of the companies’ earnings should be converted into free cash flow.

Performance since IPO As a quality investor, you don’t want to invest in the next big thing. You want to invest in companies that have already won. Only invest in companies that managed to generate a return of 15% per year for shareholders (CAGR) since their IPO.

Secular trend The trend is your friend. A lot of quality companies are active in a strongly growing market. Think about themes like urbanization (Otis), cybersecurity (Fortinet), datacenters (Arista Networks), hearing aids (Sonova), and obesity (Novo Nordisk).

Aim for companies which can grow their organic revenue with at least 7% per year in the foreseeable future.

Valuation For quality investors, the quality of the business is more important than the valuation. In the long run, your return as an investor is equal to: Return = FCF growth per share + shareholder yield +/- multiple expansion (contraction)

The longer you invest in a company, the more important the FCF per share growth will become. When you can buy a great business at a fair price, great things will happen.

Does this strategy work? Since 2010, the return of our investable universe with quality companies only was equal to 18.2% (!) per year. This is almost twice as good as the MSCI World. This means a $10.000 investment would have become $87.300.

Currently, we are not sharing our investable universe but we might in the future. We are confident that in the future the outperformance of quality companies will persist.

To summarize: As a quality investor, you want to invest in the best companies in the world. Quality companies have the following characteristics: - A wide moat - Integer management - Low capital intensity - Good capital allocation - High profitability - Attractive growth

It's a wrap! 📚 Each Tuesday and Thursday we publish an article full of investment wisdom for free. Take a look here and learn more with these 20 Golden rules of Peter Lynch:



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