Power of Quality
Third, the ‘Power of Quality’
It is not sufficient to buy stocks just on the basis of favourable price but one should also look at Quality Growth Longevity as the key to Value Investing is “Buy Right, Sit Tight”.
Every business is a capital input-output machine but a terrific business will not always require an investment of 1000 crores to earn 1000 crores. It can be achieved with less investment but with a brilliant management exhibiting terrific corporate governance. Today, there is abundant hunger in management all around us in terms of competitiveness and the drive to strive for excellence. What sets one management team apart from another is integrity. That being said, having a good business is non-negotiable because it is futile to have a great management but one which is unable to assert their greatness into the business.
In reality, it is actually possible to earn money from any company in the short run if one time their investment correctly, however, astronomical returns can only be achieved with quality companies. Quality businesses are businesses which consistently earn above their cost of capital irrespective of the business cycle, but they do not come cheap and hence it is again about identifying these companies before the market does. In true essence, Power of Timing supersedes these 4 golden rules.
Moving a step forward, we can try to quantify the term “quality” using the following parameters:-
- Return on Equity (RoE), Return on Capital Employed (RoCE) should be atleast 5% above Risk- free rate (10 year bond yield)(The current 10 year bond yield is about 6.1% (Feb 2021)). That puts the benchmark rate at about 11% which implies that a business must earn this RoE or RoCEevery year for a minimum of 5 to 10 years.
- Favourable terms of trade: A company should have a fast sustainable collection period i.e. shorter debtor days and longer payment cycle i.e. longer creditor days. The word “sustainable” here is as important as “fast” when talking about the collection period. This is because having a consistent period of debtor days shows that the company shares a good relationship with its customers.
- Operating Cash Flow and Free Cash Flow: One of my professors once quoted, “There are only two certainties in life and they are cash and death”. This saying is corroborated with the emphasis that our veteran investor puts on cash flows. Profits can be manipulated and tampered with, however, cash will always give you a true picture of the strengths and weaknesses of a business.
- Growth and Longevity of growth: It is not just important that the company grows with a high rate but also that there is scope of growth in the industry. To understand growth rate, one doesn’t need to look at a company’s current position (say, market share) but its future potential. A company with a 2% market share but very competitively advantaged with a strong moat can grow to 20% in a short span of time and that’s quintessential wealth creation. Moat is a term which is commonly used by Warren Buffet to describe a company’s competitive advantage that acts as a barrier for entry for another firm who wishes to enter the same or similar type of business. There are various sources by which a company can set up its moat, namely, cost advantage culminating into high margins, efficiency in production, high switching costs for both employees and customers, network effects in the form of a strong customer base, patents and regulatory licenses, strong brand image, etc.