How to pick quality companies when buying shares

We talk a lot about investing in quality companies. We believe that investing in a diversified portfolio of high-quality companies results in favourable investment outcomes. But what exactly is a ‘quality’ company?

Defining quality is actually very subjective but a lot of the time it can be sensed – you know it when you see it, especially after spending a bit of time researching a company. However, there are a number of things we look for in identifying quality companies that may make good investments. Below we outline some of the most important:

An economic moat

Quality companies have sustainable competitive advantages over other companies in their industry. This is often referred to as an economic moat – i.e. what protects a company from its competition. Think of a company as a castle surrounded by a moat, with the moat being the factors differentiating the company from its competitors. The wider the moat, the safer it is.

An economic moat can arise from a number of factors. It could be intellectual property, size and efficiency that are difficult to match, network effects, or high customer switching costs. An economic moat typically results in a high return on a company’s invested capital – one of the key factors we look at when assessing companies.

Strong cash flows and financial strength

Strong cash flows are crucial. At the end of the day, it’s cash that pays the bills, not profits recorded on the books. Strong cash flows provide the funds to reinvest in the business to grow earnings over the long-term, or to pay out dividends to shareholders. Cash flows are also the most important determinant of a company’s valuation.

Ideally, a company’s cash flows will be highly resilient to the economic environment (or defensive) and predictable. Often this is because revenue is recurring in nature – either because the company provides a necessity, or its customers are ‘sticky.’

Companies with lower debt levels and sound balance sheets are also more easily able to withstand adverse economic conditions or changes in their operating environment. While having some debt is beneficial (as debt is typically cheaper than equity funding), having plenty of headroom also enables management the luxury to think for the long-term.

Pricing power

A company has pricing power if it is able to increase prices without seeing a large drop-off in demand for its products or services. Similarly, a company with pricing power can maintain prices in tough economic times.

With input costs rising across the board and inflation showing real signs of picking up, pricing power becomes even more important. Companies with pricing power will be able to maintain margins in the face of rising costs, thereby protecting their bottom lines.

Good management and governance

Legendary investor Warren Buffett once said that a “ham sandwich” could run Coca-Cola, meaning that the company was of such high quality due to its brand that good management wasn’t really that important.

While companies with strong competitive advantages are less reliant on management skill than those operating in more competitive markets with thinner margins, management and governance is still a crucial factor. A company can have everything going for it – it can have good product and operate in an attractive industry, however, if management isn’t up to scratch, or its governance lets it down, it can end up being a lower quality investment.

Some aspects of good governance can be measured (such as board independence and diversity), however, often good management and governance is about doing your research and knowing the company well.

Sustainability

Increasingly, quality companies are those that are managing environmental and social risks well. These companies have an eye to the future and are ensuring that their business models are strong in a world of increasingly sustainability-minded customers, investors, and governments.

Take for example emissions. The price of carbon will only rise in the decades ahead, and companies increasingly want to deal with other companies that take emissions seriously (to lower emissions in their own value chains). Companies acting on these issues will be better placed to succeed in the future.

Structural growth opportunities

This isn’t strictly a quality attribute – mature companies can also make for a quality investment in a different way. However, we see structural growth opportunities as important in the vast majority of cases and it’s one of the first things we look for when identifying potential new investments.

Structural growth opportunities can be the result of factors such as demographics (like an ageing population, millennials), technological changes (cloud computing and e-commerce), regional economic development (the emergence of Asia) etc. Ideally, the company will have a large addressable market and a clear runway to grow in the decades ahead.