The key to successful long-term investing is to buy high-quality companies with a substantial competitive advantage at attractive prices and hold for the long-term, resisting the temptation to tinker with your portfolio in the meantime.

The hardest part of this strategy is finding the high-quality companies with the most attractive economic moats or competitive advantages in the first place, and it seems as if every investor has a different method of separating the wheat from the chaff.

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In this month’s issue of Value Investor Insight, Simon Denison-Smith and Jonathan Mills of the UK’s Metropolis Capital describe their straightforward and easy to follow method of scoring businesses on quality.

Metropolis Capital on finding high-quality businesses

Metropolis looks at three essential qualities of a business when it’s assessing the firm’s quality. The first quality is what they like to call customer stickiness, which is “essentially asking the question of how quickly a competitor can take the business away by offering a lower price.”

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The second business quality the team looks for is the company in question’s position in the market. Metropolis is looking out for the businesses that have a cost advantage over peers via economies of scale, greater experience of operating in the sector and volume of product delivered over time. A strong position in the market helps companies manage through downturns and come out stronger on the other side by taking advantage of weaker competitors to grab market share.

The third quality is some sort of unique asset that ‘s hard to replicate and difficult to compete against. This unique asset can either be in the form of a unique distribution network, an army of highly trained employees or intellectual property.

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When it comes to the topic of valuation, Metropolis uses an adjusted discounted cash flow model. The team models post-tax free cash flows for the next four or five years based on detailed inputs on revenue and expense drivers. These estimated cash flows are then discounted back to the present using the long-term equity rate of return of approximately 6.5% to arrive at an estimate of intrinsic value. Before entering a position, the share price must be at least 30% below the team’s estimate of intrinsic value.

So, if the valuation is correct, Simon and Jonathan expect the business to compound in value at the discount rate used with the rest of the return coming from the closing of the discount to intrinsic value.

Value in Ryanair

One of the companies Metropolis currently owns, which hits all of the criteria above is low-cost airline Ryanair. Ryanair has a huge cost advantage over peers. Excluding fuel costs, the company’s operating expenses on a per-passenger and per-kilometre basis are 25% lower and 43% lower than its closest discount competitors. Compared to legacy carriers its costs are 50% to 70% lower. Ryanair is also a price leader. Metropolis’ research shows that on 88% of the company’s competitive routes its prices are 27% lower on average than the cheapest alternative. What’s more, the company’s 20% plus operating margins are among the best in the industry.

So, Ryanair has a substantial competitive advantage. Moreover, the group is planning to increase the number of passengers it carries to around 180 million by 2024, a growth rate of around 8% per annum. If the company can maintain its current cost and margin advantages while achieving this growth, Metropolis estimates the shares have intrinsic value in the low €20.00s.

Another positive factor about Ryanair is that the CEO and founder O’Leary owns a stake currently worth more than €500 million in the company, so his interests are incredibly aligned with shareholders.

Metropolis Capital on finding high-quality businesses
Metropolis Capital on finding high-quality businesses