By Investment Master Class
Many of the great investors evolve over time to focus on high quality companies. In the post ‘Evolution of a Value Manager’ I outlined how Buffett, with insight from Munger and the acquisition of See’s Candy transitioned from seeking cheap companies [ie cheap PE/, price/book etc] to trying to purchase high quality companies at reasonable prices. Li Lu and Mohnish Pabrai are two Buffett disciples who have made a similar transition.
“See’s Candy – it was acquired at a premium over book [value] and it worked. Hochschild, Kohn, the department store chain was bought at a discount from book and liquidating value. It didn’t work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses” Charlie Munger
Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
The key to understanding the value of high quality companies is compounding. There is no universal definition of what high quality is but I think it's fair to say a high quality company is one which is understandable, dominant in it's industry, has a high profit margin and a sustainable rate of return which is above average. Other attributes include strong free-cash-flow, a capital light business model, a good runway for sales growth, high quality management and a rock solid balance sheet. The highest quality companies have the ability to re-invest free-cashflow back into the business at high rates of return. These are compounding machines.
“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett
In the case of See's Candy, it was a very high quality company but it didn't offer the same potential re-investment opportunity of a Coke or Gillette as it didn't have the global sales runway of these universal brands. For Buffett though, this didn't matter as See's Candy could send the profits back to Berkshire headquarters where Buffett could redeploy them in other attractive investments.
"We've tried 50 different ways to put money into See's. If we knew a way to put additional money into See's and produce a quarter of what we're getting out of the existing business, we would do it in a second. We love it. We play around with different ideas, but we don't know how to do it" Warren Buffett
"If we hadn't bought See's, we wouldn't have bought Coke. So thank See's for the $12 billion. We had the luck to buy the whole business and that taught us a lot. " Warren Buffett
So how do you identify high quality? It's important to consider common stocks as businesses and not just pieces of paper. This helps remove some of the emotional influences and human biases an investor faces and guides an investor to the key factors that will drive future earnings. Earnings are the lifeblood of the company and a company's worth is the discounted value of the earnings it can deliver over it's lifetime. While in the short term, a stock price may vary significantly from the underlying value of the business, in the long term, share prices and value converge.
To identify high quality businesses you need to think about the characteristics of the business that will determine its success over time. It's important to understand the basics of the businesses. What does the business sell? Is it a necessity, a commodity, a fad, a royalty stream? Is it subject to technological obsolescence? Why do the customers buy the product from the company and not someone else? Do they buy based on price, quality, convenience, subscription, referral etc? What demand is the product fulfilling? Is the product a small part of a much larger purchase? Is the company a win-win for all stake-holders? Does the business have some unique aspect that makes it hard for others to compete with it [ie network effects, 'winner takes all', geographic advantage, scale advantage, government licence, patent, cost advantage, strong brand, high switching costs etc]. Does the business operate in a competitive industry? Are competitors entering or exiting the industry? Does the business have lots of competitors, suppliers and customers, or few? Will technology impact the business in a positive or negative way? Can the business put up prices without impacting sales? Does the business have a long runway for sales growth? What is the market penetration? Is the business facing the law of large numbers? Does the business need a lot of capital to grow? Does the business have a structural tailwind or headwind? Is the business subject to regulatory change? Is the business improving or declining? How is the business impacted by inflation?
While investment checklists aren't a panacea for thinking they can help an investor avoid common mental short-cuts and investment pitfalls.
A business with a history of profitability through different economic environments is a lower risk proposition than a start up. It's been stress-tested by economic cycles. Some high quality businesses are boring, they don't attract competition. Some high quality businesses maybe on the cusp of a technological development that will escalate future growth. A good example was Disney, which Munger recognised owned a valuable film library, which could suddenly be monetised with the invention of the DVD.
High quality businesses have superior management who can adapt to change, are aligned with their shareholders and have a track record of deploying capital skillfully. High quality businesses also have solid balance sheets and high levels of free cash flow.
Once you've identified a high quality business the question is what to pay? Buffett paid three times book value for See's Candy and a P/E multiple above twenty for his last purchases of Coke. So if you can find a compounding machine it can be worth paying up for.
"Is Costco worth 25 times earnings? I think: Yes. Am I ready to sell any Costco? No. Would I buy more Costco at 25X earnings? I’m probably wrong, but I’d certainly rather buy Costco at 25X earnings than 90% of the other stocks." Charlie Munger
The difficulty is in identifying the few businesses that will grow into their multiple and beyond as most won't. Allan Mecham of Arlington Capital noted "Home Depot which in 1984 traded for 48 times earnings and even from such a lofty valuation went on to compound at 20% over the following 29 years" .. but "Home Depots are extremely rare". Paying too much for a business can result in poor returns.
Conversely, value traps tend to have characteristics at the other end of the spectrum of high quality companies. They are optically cheap, hence the name value trap. These businesses are commonly referred to as 'melting ice cubes' as the intrinsic value of the business melts away.
“If you’re in a lousy business for a long time, you’re going to get a lousy result even if you buy it cheap.” Warren Buffett
A good example of value traps over the last ten or so years are businesses which have been subject to technological obsolescence. These businesses in many cases were high quality compounding machines in an earlier life but who have since seen their barriers to entry destroyed by some innovation. Kodak is a good example. Kodak dominated the market for film and photographic paper prior to the invention of the digital camera. In the beginning digital camera images were seen as inferior low resolution. Then at a sudden tipping point, when digital camera prices plummeted and quality improved, Kodak's earnings and stock price was decimated.
A similar thematic played out with newspapers. The newspapers had few competitors, huge scale advantages, and a monopoly on advertising and news. Slowly at first, classified websites offering better search functions and lower costs started to gain a following. A tipping point was reached and many newspapers went bankrupt.
Cable TV operators are facing a similar threat from high speed internet because now you no longer need a cable network for distribution. The cable network was once the barrier to entry. Netflix doesn't need a cable monopoly or a local TV licence to deliver content to its customers. Anyone in the world with high-speed internet in now a potential customer. The more customers Netflix can sell to, the more it can pay for programming, the more customers it can attract. It's a virtuous circle.
The internet has decimated traditional businesses and provided the means for the early adopters to move to a 'winner takes all' position which wasn't previously possible.
The common characteristics of value traps are declining businesses. While the impact at first tends to be slow, it escalates rapidly when adoption hits a tipping point.
Value traps can also arise where management is misaligned with investors and/or makes poor capital allocation decisions. Even in high quality businesses management who deploy capital poorly can destroy value. Seeking businesses where management is aligned through stock ownership or appropriate incentives helps avoid these problems. Vetting managements track record should be part of the due diligence process.
In declining businesses it is common for management to try and buy their way out of trouble by making acquisitions in unrelated fields to dilute or cover-up the core business performance. This almost always ends badly.
The best way to avoid value traps is to firstly think about the business and the forces that could harm its earnings potential and focus on high quality companies