It would come as no surprise to many of you that I aim to purchase high quality companies when investing. Unfortunately, quality is hard to define; perhaps it is a case of “I’ll know it when I see it”. Personally, I had struggled to come up with a definition of what a high quality company is for quite some time. Here are my guidelines that I have developed over many years to identify and ensure that I invest in the best quality companies Australia has to offer.

What traits do High Quality Companies share?

High quality companies have similar characteristics, including:

  1. A consistent and disciplined approach to capital allocation
  2. Strong returns on investment capital
  3. Long term growth opportunities
  4. An attractive or supportive industry structure
  5. A sustainable competitive advantage

These shared characteristics are in my opinion necessary for a company to be considered high quality. Below, I expand on what precisely I mean by these 5 characteristics.

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1. A Disciplined Approach to Capital Allocation

This is the most crucial of the five characteristics, as decisions made by management in allocating capital are ultimately responsible for either creating value or destroying it. There are three main ways a company can allocate capital: growth capital expenditure; mergers and acquisitions and distributions to shareholders (either via dividends or share buybacks).

Growth Capital Expenditure

Growth capex is the internal investment aimed at creating future organic growth. This is different to maintenance capex, which is expenditure that is required to maintain the current operating levels of the business. Examples of growth capex may include things such as the purchase and fit-out of new stores for a retailer, for example.

An example of a company that has delivered excellent returns on growth capex is JB Hi-Fi. Rolling out over 150 stores over a 10 year period, the company has managed to deliver strong growth both from new stores and older stores as they mature. This has delivered excellent outcomes for shareholders, and is a great example of the positive affects of a disciplined approach to growth capex.

Mergers and Acquisitions

My personal opinion is that all investors should be wary of management teams bearing growth stories via transformational acquisitions. In my experience, large scale mergers and acquisitions very rarely work, with more capital destroyed via dubious tie-ups then can accurately be counted. Particularly bad in Australia are resource companies, who have a tendency to blow up large chunks of investor capital during resource cycles.

What has worked though are small scale “bolt-on” acquisitions. Typically, these acquisitions are small compared to the larger company, and they are either in the same industry or extremely complimentary to the businesses current operations. A good example is one of our dividend aristocrats, AP Eagers. By continually buying attractive car dealerships, AP Eagers can continue to build scale, entrenching its competitive positioning. Because AP Eagers has completed so many of these acquisitions, I have comfort that a misstep is unlikely, and even if the acquisition does not work as planned, it is a small mistake rather than a catastrophic one.

Distributions to Shareholders

The final option is to return capital to shareholders either via dividends or buybacks. Excess cash should be returned to shareholders, as company management tends to spend any spare capital it can lay its hands on, and not always to shareholders benefits. A clear, consistent and sensible dividend policy is important for me to consider a company high quality.

2. Returns on Investment Capital

By measuring returns on investment capital over the medium term, we can gain an understanding of how effective management’s capital allocation decisions are. It also gives an insight into the competitive positioning of a company. A high quality company will deliver returns on investment capital substantially in excess of its cost of capital, and will be relatively consistent about delivering those returns as well. While a history of delivering consistently high returns on capital does not guarantee the same in the future, in my experience it makes it far more likely.

Returns on Equity

ROE has long been useful as a measure for returns on capital. It is a bit of a blunt instrument, with the denominator being an accounting measure – equity can differ due to accounting treatments. Write downs and debt levels also affect returns on equity, making comparisons between companies within industries difficult. You should be particularly wary of companies that increase returns on equity via the use of leverage for obvious reasons.

Cash Flow Returns on Invested Capital

I have always preferred to understand a companies earnings quality via the use of cash flow. You can use cash earnings (i.e. net profit less accruable earnings) and divide by all capital employed in the pursuit of these cash earnings; this will give an accurate representation of the returns generated by the business.

EBIT Margins

Slight but sustained increase in EBIT margins over time can also indicate a high quality company. You should be wary of companies that see large swings in EBIT margins, as this can indicate that some aspects of the business are out of management control. A company that can achieve high EBIT margins, particularly if higher than peers, often has a sustainable advantage.

3. Long Term Growth Opportunities

By far the most difficult aspect of business analysis is determining the future growth prospects of the business. There are some shortcuts to help you find businesses with a long term opportunity. The first (and best) is an end market that is growing. In the absence of end market growth, businesses will compete for market share, slowing potential growth. Structural growth, driven by trends such as ageing populations, urbanisation and increasing health care costs are good examples of end market growth.

The second opportunity is often geographic expansion. I would be extremely cautious with Australian companies attempting to expand overseas for the first time. Unfortunately, Australian businesses have a long and undistinguished history of destroying shareholder capital in both the US and the UK.

4. A Supportive Industry Structure

In this area, I am looking for businesses with strong oligopolistic structures, such as supermarket retailing in Australia, or localised monopolies, such as vital infrastructure (for example, toll roads and airports). These enjoy significant barriers to competition, ensuring that the effort to compete is far too high.

A good indication of supportive industry structures are industries or niches where there are participants who have long operating histories. This is a clue that the industry is supportive and profitable.

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5. A Sustainable Competitive Advantage

In my experience, sustainable competitive advantages are driven by strong network effects or technology.

Network Effects

There are two excellent but different examples of network effects in Australia. The first is Realestate.com.au (REA) and the second is Transurban(TCL). REA derives its network effect due to a virtuous cycle: users use the site because a significant majority of house listings exist on the site; the site has the most listings because it captures the most attention from consumers. In this way, REA compounds its advantages against its peers, making it more dominant over time.

Transurban benefits from an entirely different network advantage. By already owning a significant majority of urban tollroads, Transurban can bid more confidently for new toll roads that expand its reach, knowing that this will further entrench its position. This also has the effect of making it the preferred bidder for new toll roads, again compounding its advantage.

Technology

Australia does not have a large amount of tech-based companies with what I consider to be sustainable competitive advantages. We do have a number of health care companies that have extremely strong competitive positions owing to long and well developed research and development programs. With companies such as Cochlear and Resmed acknowledged as market leaders in their field, these companies have what I consider to be sustainable competitive advantages.

Conclusion:

In this article, I have outlined the five characteristics that I believe make a company high quality. Companies displaying two or more of these characteristics typically trade at high multiples – companies exhibiting all of these characteristics are generally extremely well held and extremely expensive to boot! Nonetheless, by focusing on these areas, you can determine the quality of businesses and determine the likelihood of the business delivering a compounding income stream over time.

Whats your favourite way to identify a high quality company? Let me know in the comments!