In the realm of investing, few factors are deemed as crucial and yet are as nebulous as the concept of quality. Depending on who you ask, investment quality generally brings up discussion on a plethora of soft and hard criteria – all the way from management credibility and views on the business model, through to more concrete concepts such as gearing levels and profit margins. Contrasted against the mathematical backdrop that is the world of finance, assessing quality is often more akin to reading tea-leaves or searching for meaning in the stars.
In order to be truly useful, we believe that quality needs to be more narrowly defined. While it may be difficult to subjectively determine the quality of a company, it is easier to work backwards from the outcome.
Ultimately, the quality of a company is demonstrated in its ability to generate a high return on invested capital, and to sustain that high return over time. A subjectively lousy business with a sustained high return on capital is likely of higher quality than a subjectively good business with no/low return on capital.
By investing in high quality companies at a reasonable valuation, one should theoretically, over the long term, be able to approximate the level of return on offer within the invested company (assuming you pay a fair price). Quality enthusiast Charlie Munger has said as much: “Over the long term it is hard for a stock to earn a much better return than the business that underlies its earnings… if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.”
At first glance, this fact has not escaped market participants, with charts like the below littering the internet.
Look at the chart again. What does it really tell us? If we dig into the maths, EV/IC divided by Return/IC can of course be simplified to just EV/Return. The relationship represented by the linear trend line therefore shows a consistent EV/Return multiple for all the businesses (about 20x in this case), regardless of the level of return that can generated by a set level of invested capital.
We believe business that can generate and sustain a high return on invested capital should justify higher earnings multiple. In practice, companies that generate a higher return on capital are a) able to compound shareholder value at a greater level through reinvestment of cash flow streams, and b) are better protected in an environment where the cost of capital is high or rising, or returns deviate.
While the importance of a high ROIC is sometimes understood and priced by the market, the importance of its sustainability is often overlooked. As has been repeated over and over throughout history, industries that generate a higher return on capital tend to attract more capital, and as the competition in these industries start to heat up, margins and returns proceed to melt way.
How does a company protect its ROIC against the inevitable army of invading capital? Through building and maintaining a wide moat. Economic moats can take various forms, from legal protections like regulatory licenses and patents, to brand power, network effects and cost advantages. However, not all moats are equal, and this is where thorough consideration and analysis is required.
A moat built on the basis of quality management, for instance, is not necessarily a wide one. Buffett once quipped that one wants to buy companies that can be run by idiots, because some day they will be. A cost advantage might also be viewed as a good moat, but it is the sustainability of that cost advantage that needs to be investigated. New industries often generate mouth-watering returns, as the first movers enjoy the lack of competition. These may look like high quality businesses at the outset, given the high returns on invested capital, but these first movers are often not the last ones left standing when the competition moves in.
In evaluating potential investments, we always tend to drift towards companies that have a strong and easily explicable moat. An example would be our long-standing investment into the local casino operators, Tsogo Sun Gaming and Sun International. These companies operate a virtual duopoly in the land-based casino market in South Africa. New capital is precluded from entry through the limited number of casino licenses available and the stringent requirements for holding a license. The result – decades of strong operating margins and high returns on invested capital.
Another example can be found in one of our port operator holdings, Grindrod, which operates the booming port of Maputo. As you can imagine, there is a mountain of regulatory and logistical hurdles to climb before a port can be built. Furthermore, the position of this port puts it in the enviable position of competing directly with the perpetually underperforming and mismanaged state-owned ports in South Africa. As a result, Maputo port has been able to sustain and significantly grow its market share over the last few years.
The ability to assess the strength and sustainability of an economic moat, and not just identify companies with a high return on invested capital, remains complex. At Steyn Capital Management, our analysts operate as generalists, without a specific industry focus, and have many years of experience evaluating hundreds of different businesses across various industries and geographies. We believe this provides us with a superior foundation when evaluating business quality, and allows us to take advantage when markets are mispricing quality businesses.
While the merits of quality are clear, it should not be assessed in isolation. It is only when quality is combined with a determination of value that it becomes truly powerful. By investing in high-quality companies at a reasonable valuation, investors can potentially earn returns that outpace the broader market.
A final disclaimer worth repeating, is that few, if any, moats are truly impenetrable. Therefore, ongoing monitoring of the competitive landscape is required to ensure that the investment thesis remains intact.