Part I of the series looked at how Burgundy assesses the quality of a business via three elements – business characteristics, financial attributes and management – and examined the specific business characteristics that help to define a quality business. Now, let’s turn our attention to the second element of quality.
Bernstein Likes The Value Factor Free Cash Flow… A Lot
There are three financial attributes that make for attractive investments:
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- Strong balance sheets
- Low capital requirements
- Growth in free cash flow
When selecting companies for inclusion in our clients’ portfolios, we focus on companies that have strong balance sheets. In layman’s language, we want to invest in companies that don’t have a lot of debt. Some debt on a company’s balance sheet can be good because it allows the business to create financial leverage, which enhances the company’s earning power. However, in an economic downturn, too much debt can be crippling; the business may require all of its available earnings and free cash flow to service the debt’s interest costs with little or nothing left over to reinvest in the business or to pay to shareholders. One example of a company that we own on behalf of our investors with a fortress-like balance sheet is Berkshire Hathaway. Not only did Berkshire Hathaway weather the great recession of 2008-09, it used the strength of its balance sheet to make a number of investments during the financial crisis in companies like Goldman Sachs, General Electric and Swiss Re. Collectively these investments have turned out to be accretive to Berkshire Hathaway’s profitability and ultimately its share price.1
Next on the list is a company’s capital requirements. Some businesses have high capital requirements, which means they must reinvest a substantial portion of their earnings back into the business just to remain competitive. For example, an auto manufacturer must reinvest a significant amount of capital to maintain its plants and equipment. We often shy away from these types of cyclical, capital-intensive businesses because they tend to experience large swings in their profitability and correspondingly large swings in their stock price. We much prefer businesses that have low capital requirements. One such example would be a business called Cookpad Inc.
Cookpad is Japan’s largest online cooking recipe portal. What makes this business interesting is that the content for its website is provided by its 60 million monthly active users. Cookpad is not subject to the hefty reinvestment needs of most media businesses which are typically required to reinvest a sizable portion of revenue to produce and/or acquire content on an ongoing basis. In the case of Cookpad, other than the capital required to maintain the online portal and a small spend on advertising and promotion, required capital reinvestment is modest. Thus, much of the subscription revenue paid by its users as well as the revenue paid by industry participants to advertise on the website flow to the company’s bottom line.
The final financial attribute we look for in a business is growth in free cash flow. Free cash flow can be defined as the cash that a company generates after spending the money required to maintain its operations. An example of a company that has been able to consistently grow its free cash flow is PepsiCo, Inc. Pepsi’s ability to do so has allowed it to regularly increase its dividend year after year for more than 25 years.2 A consistently increasing dividend is the signal of a healthy business and these dividend increases have helped support a robust return for Pepsi’s stock price.
As you may have deduced, the framework laid out in these posts is just that – a framework. It is used to guide our decision-making, rather than be the “be-all-end-all” in deconstructing quality. The framework, combined with our judgment based on experience and disciplined practice, is meant to lead our Investment Team to more informed, consistent decisions. The qualitative nature plays at least an equal role – if not much more – than the quantitative, and in our final post we will explore this further when we examine the final element: assessing a company’s management team.
- Berkshire Hathaway annual reports, 2009-2016
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.
Article by Greg Dowdall, Burgundy Blog