The Fog of Quality
As investors in public companies, we often talk about business quality. We use such terms as ‘good companies’ and ‘good management’. High business quality often entails competitive advantages, including strong consumer brands, high customer switching costs, etc. If maintained over years, these advantages should then translate into strong pricing power, i.e. the business can raise prices over time, and a growing market share.
Numerically, an advantaged market position can be measured via above-average returns on equity (ROE) or total invested capital (ROIC). The latter has become increasingly popular among professional investors and is calculated as after-tax profit divided by the capital invested in the business to-date. A strong competitive advantage is then meant to produce above-average returns on capital for many years and translate into attractive stock returns.
There are several problems with using ROIC as a shorthand for business quality. First, investors tend to rely on a historic, static assessment of quality, which may not accurately reflect present or future conditions. For one, the invested capital in the ROIC calculation reflects financial resources that might have been deployed into the business over decades. Old capital makes the formula less relevant since we look for returns on the more recent reinvestments into the business.
Businesses are also dynamic organizations with many profit-seeking competitors—both old and new—constantly looking to take at least some business away from established firms. Think Netflix taking a significant amount of viewership time away from traditional cable companies who for decades enjoyed elevated profitability.
Third, a structural shift in an industry can curb demand for a product and diminish its profitability. Tobacco companies, for example, had to adjust to shrinking demand in North America as consumers pursued healthier lifestyles and as strict laws and higher excise taxes made smoking less tenable.
The troubling part is that quality deterioration often happens slowly and without investors’ awareness. Corporate presentations and media appearances tend to lag shifting customer behavior. So, after buying into a historically high-quality business, investors may eventually experience subpar investment results.
How then should investors work through this fog of quality, to discern the true state of a company’s fundamentals? There are no shortcuts, no simple formulas. It takes significant effort and time.
The key question is whether a given product or service will still be as indispensable to customers going forward as it has been in the past. Investors should conduct field work, including conversations with customers, to understand their preferences.
Trade shows are useful since they are concentrated gatherings of companies and their customers. Trade magazines and people inside our expert networks are also good sources of product and industry insights. Research across multiple industries is also beneficial since emerging products and industries can often impact adjacent ones. Think the impact of GLP-1 weight loss drugs on the food and beverage industry, for example.
Finally, to better gauge returns on recently deployed capital, investors should use additional cash flows generated by the business following each incremental reinvestment of retained earnings or capital raised from outside sources. The time between the deployment and cash returns depends on each industry. Some businesses generate cash on investments made in the same year. For many others, that process takes years.
The complexity of running high-quality companies in a hyper-competitive world is not to be understated. It takes a high-caliber management team to obsess over the customer, to be able to predetermine customer preferences, and to keep an open mind about when to pivot, to take risks, and to admit mistakes.
In our experience, long-term oriented management teams—a rare commodity these days—are best positioned to manage this complexity. Long-term orientation means that managers are less worried about squeezing the most out of the company’s existing competitive position. Instead, they strengthen its existing advantages and position the business to succeed over decades.