By Burgundy Asset Management
If you are at all familiar with Burgundy, likely you have heard time and again that we invest in “quality” companies when the share prices of those companies are trading below their “intrinsic values” (that is, what we believe is a company’s true worth).
But what does that really mean? Isn’t every active investment manager looking to do the same? Yes…and no. While investing only in quality businesses is the aim of every market participant, many active managers do not want their portfolios to look too different than the underlying benchmark, against which their performance is evaluated. Doing so and then underperforming the benchmark could get them fired. Thus, if a company represents a large position in their benchmark, investment managers may feel pressure to own it regardless of the quality of the underlying business. In their eyes, they cannot afford not to own it. The thinking is, it’s better if I’m wrong with the market than wrong and different than the market. This can lead to some unfortunate outcomes, as exemplified by the number of active managers that had significant allocations to Nortel Networks in the late 1990s or Enron in the early 2000s.
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In contrast, the Burgundy investment process is benchmark agnostic. To put it another way, we don’t use the composition of a benchmark as our main guidepost in constructing a particular portfolio. In each of our regional portfolios, we invest in a limited number of businesses (typically 20-30) and each business is selected based on its quality and its price. We look for the highest-quality businesses we can find at market prices that underrepresent our estimate of those businesses’ true worth.
In assessing the quality of a business, we look at three key elements:
- Business Characteristics
- Financial Attributes
This post is the first of a three-part series examining the elements of a quality business, beginning with the first key element.
The first element, business characteristics, leads us to businesses that have the potential to outlast and outperform their competitors over the long term. There are four characteristics of a business that we find particularly attractive:
- The business operates in an industry that has barriers to entry
- The business operates in an industry where there is limited competition
- The business proves to be economically resilient
- The business demonstrates industry leadership
Any one of these characteristics might prompt us to take a closer look at a business. A combination of these characteristics would strongly pique our interest.
An example of a business we own that demonstrates more than one of these desirable characteristics is the Canadian National Railway Company (CNR). Let’s look at how this business ticks the boxes.
First, a barrier to entry exists because it would be next to impossible to acquire the land and build the infrastructure to start a new railway. Second, along with Canadian Pacific Railway, it operates a responsible duopoly in Canada and is one of only six or seven Class One railways in North America, inferring limited competition. The fact that transporting goods by rail is three times more fuel efficient than transporting by truck further limits competition.
CNR demonstrated itself to be economically resilient during the Great Recession of 2008-09. Let’s look at its Operating Margin, which can be described as a measure of a company’s profitability. Before the financial crisis, in 2007, CNR’s operating margin was 36.4%. It declined to 32.6% in 2009 during the depth of the financial crisis but rebounded quickly back to 36.4% in 2010.1 The decline in profitability was small and the recovery was quick. Part of this resiliency can be attributed to its diversified customer base. CNR has customers come from a number of industries including Petro and Chemical, Metals and Minerals, Forest Products, Coal, Grain and Fertilizers, Intermodal, and Automotive. This diversification of its revenue sources protects it from being overly exposed to volatility within a particular industry.
Finally, CNR demonstrates industry leadership because it operates the largest rail network in Canada (earning C$12 billion in revenue in 2016),2 which provides the company with both scale and cost advantages relative to its competitor, Canadian Pacific Railway. It is also the only railway in North America with a track network that stretches from Canada’s East Coast to Canada’s West Coast and down to the Gulf of Mexico.
While not every company we own will check every box, we do our best to ensure the quality of the underlying business is strong. To quote Warren Buffett, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
- CN website https://www.cn.ca/
This post is presented for discussion purposes only and select securities may be used as examples to illustrate Burgundy’s investment philosophy. It is not intended to provide investment advice and does not consider unique objectives, constraints, risk tolerances or financial needs. Under no circumstances does this post suggest that you should make investment decisions based on the content. Past performance is not indicative of future results. Investors are advised that their investments are not guaranteed, their values change frequently and past performance may not be repeated. The information contained in this post is the opinion of Burgundy Asset Management and/or its employees as of the date of the post and is subject to change without notice.