This is one of the best books to read for long term investors
Quality investing : owning the best companies for the long term.
by Lawrence A. Cunningham,Torkell T. Eide, Patrick Hargreaves.
While the whole book was a fantastic read, one thing I really found useful was patterns they shared to look in quality companies. When looking for quality companies, the desired outcome is always clear: strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Yet the building blocks that enable companies to achieve these results vary widely, Examine these routes, however, and patterns emerge - similar combinations of strategies, techniques, or capabilities that transcend companies or industries, Patterns are great reusable templates and ones which can be used successfully across different companies and sectors. This then becomes an essential tool kit to develop in search of finding quality companies. Let's learn some of the patterns discussed in the book
Recurring Revenues
Recurring locked in revenues lead to predictable cash flows and in turn exhibit business quality, Keep below the table in mind
Type License Service Subscription Common In Large Software Companies Industrial Companies Marketing, Software as Service companies, Platform Business Key Success Factor The software should need maintenance and support on Mission-critical operations of Organisation (SAP, Oracle, Infosys Finacle) Service models are strengthened 1) when the risk of damage from product disruptions are regulated or mandated by law 2) the breakdown of a piece of equipment is likely to cause economic disruptions for its owner (AIA Engineering) 3) Wide Service Network (BKT) 1) Mass Acceptance of platform (AWS, Atlassian, Shopify) 2) Embedded in Automated System (STRIPE)
2. The Friendly Middlemen
Many companies require a friendly middleman to reach their end users, Being a friendly middleman can provide great leverage over suppliers
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Banks in India like HDFC, ICICI are the middlemen used by AMCs and Insurance companies to distribute their products. Profit analysis of these banks would indicate that being friendly middlemen has added significantly to their bottom line
3. Toll Roads
Many large industries are served by niche suppliers whose services or products may represent a relatively immaterial proportion of that industry’s cost base, but which are crucial to its successful operation. These then create a very successful business model for suppliers
For Toll, roads look for below
Type Golden Standards Magic Ingredients Common In Benchmarking and Certification, Auditing Companies Training companies Niche manufacturers Key Success Factor 1) Certification becomes a regulatory requirement - Rating Agencies (CRISIL) 2) Training is critical to perform the Job Small (Cost wise) but Critical component of the end product Chemical manufacturers (Atul) Packaging for high-end medicinal goods
4. Low-Price Plus
Smart operating choices creates low cost - Savings are passed onto Customers - The customer keeps coming back - Due to economies of Scale the operating costs lower more
A very difficult model to build but significant benefits can be reaped when such a pattern is visible in the company then it becomes a winner. Great examples are COSTCO, IKEA, DMART
5. Pricing Power through Brand Strength
Pricing power is a highly attractive feature: a company that can regularly raise prices above cost inflation is assured of growth, top-line and bottom. With no capital expenditure required to raise prices, enhanced returns on capital also result. The problem is that pricing power is often more conjectural than real – it is frequently discussed but rarely achieved.
One indication of pricing power is sustainable gross margin improvement while monopolies are often regulated or disrupted. Often Brand Strenght creates that pricing power prominent example are APPLE, NESTLE INDIA , Hindustan Lever 6. Innovation Dominance Innovation must be profitable to make innovation dominance attractive. Not all innovation makes business better. In many industries, companies must innovate constantly simply to defend their position. When such innovation comes alongside declining margins (as R&D expenses are not covered by incremental sales), a company is engaged in costly cannibalization, not value creation.
When looking for Innovation domination look for below
Type Innovation Culture R&D Led Innovation Traits High frequency of new products increasing sales velocity (Ajanta Pharma) A large share of Industry R&D budget spent by Company (TESLA, GOOGLE ,BIOCON)
7. Forward Integrators Under the right conditions, forward integration can be hugely valuable. There are several types of forwarding integration
Type Moving up in Value chain Franchising Opening up Online, Physical presence Traits Producing more value-added products (MRF, SUVEN) Moving closer to the customer and owning the customer experience (CERA - CERA Style Studios) Use the power of Brand to expand using third-party capital (DOMINIOS -JUBLIANT FOODWORKS) For e-companies opening a physical presence (iSTORE) For traditional companies opening online presence
8. Market Share Gainers Quality companies exhibit a constant increase in market share, however, a clear filter to put on would be to look for companies which are not gaining merely by lowering price but by being lowest cost producer and winning customer due to favorable product and service They should not resort to discounting only Discounting can be seductive in the short term: it boosts sales , enables companies to hit their profit targets , and even brings gains in market share . But it is dangerously addictive. When companies see that it works once , they are often tempted to do it again . Competitors typically follow suit to protect market share and the industry starts teaching customers to expect persistent discounting . Once that occurs , the industry has trapped itself 9. Ability to Dislodge One should invert and see how hard it is to dislodge a company from the current position. Can throwing tens of billions of dollars of capital can create a worthy competitor if the answer is no then there is likely to be a competitive advantage which can not be broken easily. Even if you pour tens of billions of dollars it will be difficult to dislodge United Spirits from its current market position in liquor sales in India due to its Brands, Manufacturing facilities (in various states) and distribution network 10. Leadership & Culture Quality companies tend to have a strong sense of culture based on a core set of common values that drive success. These values vary by company, but examples include cost consciousness for a low-cost provider, scientific curiosity for a research-driven company, and team spirit in collaborative production businesses Leadership is difficult to assess but critical to ongoing sustainable long term value creation, Some traits to look for are
Stock ownership
Long term orientation
Impeccable Execution track record
Trustworthiness
What other patterns can you think of? Leave them in comments