“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors ” – Warren E. Buffett
“The risk of paying too high a price for good quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at times of favorable business conditions. ” - Benjamin Graham
In our previous articles, High Quality Stocks in Developed Markets and High Quality Stocks in Emerging Markets, we discussed ourframework for selecting High Quality businesses and a quantitative process to select high quality businesses. In this article, we will discuss the investment returns to a similar process applied to Indian equity markets. Additionally, we will show the risk and returns to a manually selected basket of high quality businesses in India.
As we stated in the articles referred to above, a high quality business possesses significant competitive advantages that are durable. The quote above by Warren Buffett makes the same point as Buffett states that the key to investing is about two factors: one, the extent of the competitive advantage of the business and two, the durability of that advantage.
A business that enjoys significant competitive advantages and is able to sustain such advantages over extended periods shows that business has been able to keep competition at bay. Most analysts as well as business observers usually associate a depicted ability on part of the business to keep competition at bay with presence of durable competitive advantages. However, a business’s success at fending off competition doesn’t always mean that the business possesses durable competitive advantages.
Factors That Help Keep Competition Away
We contend that there are three primary factors that help a business keep competition at bay. We discuss each one of these factors below.
1. Business’s moat. A business that possesses competitive advantages that are durable have wide moats built around them that serve to protect them from competitive actions. In Calibrating a Business’ Competitive Advantage, we identified six sources that give rise to durable competitive advantages and are driven by the underlying characteristics of the business.
2. Superior management. It is possible that a business is blessed with a management team that has been great at anticipating and effectively counteracting competitive actions in a manner that have allowed the business to generate superior returns on its capital. However, we do not think of such businesses as High Quality businesses as such a competitive advantage is likely to be eroded by retirement or departure of the executives or because of missteps by the same management team the next time around.
3. Temporary demand supply imbalances driven by market structure. In some markets, especially in emerging economies, it is possible that a business enjoyed competitive advantage over extended period of time driven by inefficiencies in the market structure that did not allow for effective competition. As these countries open up their economies and make it easier for businesses to start and exit, such demand supply imbalances disappear. Along with the disappearance of such imbalances, business’s competitive advantage also disappears.
An investor who is able to successfully identify businesses that are blessed with superior management or businesses that will continue to benefit from demand supply imbalances driven by market structure, will likely achieve superior investment results. However, we find that we have limited capabilities at identifying businesses blessed with either of these factors. Accordingly we choose to focus our efforts and resources where we think we indeed have superior capabilities; at identification of businesses that possess wide and deep moats.
Investment returns to quality in Indian markets
This article discusses the application of quality-driven investing in Indian markets. In the discussion that follows, we lay out the framework for selecting high quality businesses and the risk-return of a basket of high quality stocks in Indian markets.
1. Qualitative Factors
At Multi-Act, we have spent more than 15 years developing and refining our process for identifying high quality businesses. Our internal research process assigns every company we follow a quality rating, referred to as its “grade.” There are several components of our process, some of which lend themselves to quantitative modeling while others don’t. As discussed above, the defining trait ofa high quality business is the existence of competitive advantages that are durable. The important point to note here is that this is a component that does not lend itself to quantitative modeling.
The existence and sustainability of competitive advantage are the most important criteria in our classification of a business as high quality. This is driven by our assertion that much of the investment returns that accrue to investors from the quality factor depend on the ability of the business to persist with supernormal returns on capital. This in turn depends on its ability to keep competition at bay. Given our inability to model this component, we believe that our manually selected list of quality businesses will likely generate superior risk-adjusted performance as compared to the quantitatively selected basket that is discussed here.
2. Quantitative factors
There are some key characteristics of a high quality business. A high quality business generates superior returns on capital - the stronger the competitive advantage, the lesser the impact of competition and the higher the returns on capital. Returns on capital of such businesses tend to be persistently high. Further, such businesses have a very healthy relationship between their accounting profits and their economic profits. Additionally, our high quality businesses possess good balance sheets, so financial risk isn’t a significant factor driving our investment returns.
As shown in Exhibit 1, our process includes three characteristics that lend themselves to quantitative analysis. Within each one of the characteristics, our investment research process utilizes a multitude of measures spread over several years of the business’s history. However, for the sake of simplicity, we have chosen one measure to represent each quality characteristic.
For the purposes of this article, we measured returns on capital by return on equity (RoE). A high RoE indicates the existence of competitive advantage and the persistence of this variable suggests its sustainability.
It is possible for the management of a company to manage its RoE. To the extent that earnings are manipulated, they will impact RoE. Further, RoE is affected by corporate transactions including buybacks, acquisitions and restructurings. To ensure that the earnings component of the RoE is not a result of financial creativity, we use free cash flow over earnings (FCF/EPS) to calibrate the quality of earnings. We have found that this measure filters out companies with suspect accounting numbers. Finally, we measure financial safety by net debt over free cash flow (N D/FCF). This measure indicates the number of years of free cash flow needed to repay the debt.
Table 1 provides summary statistics on each of the quality factors by year.