Can you find quality in investing?

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Walter Scott fund manager Paul Loudon outlines the green lights and red flags investors should consider when doing due diligence on companies in their portfolio.

“Even though quality cannot be defined, you know what it is.” So runs a line in Robert Pirsig’s classic autobiographical novel Zen and the Art of Motorcycle Maintenance. Or consider a more investment-orientated take on the nature of quality, this time from Warren Buffet, the seer of Omaha: “The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

For Walter Scott fund manager Paul Loudon, both quotes talk to the difficulty of finding and defining quality in investing. In the abstract, he says, quality can be a nebulous concept – but in real life that doesn’t mean it’s impossible to find.

Step one: Quantitative analysis

“The first order of business for Walter Scott as an investor,” he says, “is to narrow down that initial universe of opportunity. In global equities that can be vast but if you employ a quantitative filter you can begin to whittle it down to a manageable group of companies.”

In Walter Scott’s investment process, that first filter focuses on a set of standard characteristics a company needs to possess to make it over the first hurdle:

  • A robust track record of growth
  • Strong and stable margins
  • Sustained high returns on capital
  • Impressive cash conversion
  • Solid balance sheets

Point to remember: Cash is king. “A key metric for this stage of the investment process is the level of cash generated from capital deployed. It’s one of the most important measures in determining quality,” says Loudon.

Step two: Qualitative analysis

Once an investor has whittled down that initial broad universe through quantitative analysis, the next step is to bring in a qualitative filter. Here, the first questions to ask are around management:

  • How good are they at allocating capital?
  • Do they foster sustainability?
  • Do they think and act for the long term?
  • Do they operate with integrity?

“Good management can make or break a company,” Loudon observes. “It’s one of the key characteristics we aim to identify when we undertake due diligence.”

The next step is to consider growth: Is the company operating in growing markets, is it making market share gains, is its growth organic?

Says Loudon: “The question of growth is a fundamental one. If a company operates in growth markets, it means they’re not overly reliant on things beyond their control. Regardless of the macroeconomic backdrop they’ll benefit from those secular tailwinds. Likewise, if they’re gaining market share at the expense of competitors, that can shield them somewhat from industry cycles. Finally, being able to grow organically without the short-term sugar rush of M&A is a hallmark of quality in our view.”

Point to remember: Look to the future. “Many financial metrics are backwards-looking but it’s what happens in the future that matters,” says Loudon. “This is where these qualitative insights come into their own.”

Step three: A further qualitative overlay

The next layer of qualitative analysis is all about control – and the degree of control a company has over the course of events. Those in charge of their own destiny are, by definition, less subject to the vagaries of fortune and so are more likely to stand the test of time. Here, Loudon highlights four key attributes of successful businesses:

  • They are not over-reliant on individual customers or suppliers
  • They do not face regulatory headwinds
  • They face limited risk of substitution or obsolescence
  • They are subject to rational competition

Intertwined with this question of control is that of barriers to entry – or, in Warren Buffet parlance, economic moats. “It’s a fundamental law of economics that any part of the economy where companies can achieve high returns will attract competitors,” says Loudon. “Economic moats help incumbent businesses defend themselves from newcomers as well as existing threats.”

Point to remember: Do your homework. “It’s all very well talking about the importance of control and economic moats but it often requires deep research of any given industry to truly understand the nature of the risks a company will face,” says Loudon. “This is where decades of experience can make a real difference.”

When it comes to barriers to entry, Walter Scott seeks businesses with the following qualities:

  • They have industry-leading technology
  • They leverage economies of scale
  • They benefit from network effects
  • They have an exceptionally strong brand
  • There are high switching costs for customers

Point to remember: A good reputation takes time to build. Says Loudon: “Strength of brand is another important marker of a quality company. It comes down to integrity, reliability and history – the ability to deliver on promises time and time again. A good brand can take decades to build and that in itself can constitute an economic moat.”

The final step: Nice-to-haves

One further set of criteria the Walter Scott team seeks when doing due diligence comes under the ‘nice-to-have’ heading. That is, a set of qualities that, while not a dealbreaker if absent, can bolster the investment case if they are apparent.

These include companies with solid pricing power, recurring revenues, and those producing low-cost yet mission-critical goods or services.

For Loudon, the research necessary to really understand whether or not a company can make the grade is an exhaustive undertaking – but one with evident rewards.

“Of course, it’s nigh on impossible to find businesses with every single one of the qualities we’re looking for,” he concludes. “But finding one that ticks most of the right boxes while avoiding most or all of the red flags will be a good start for any buy-and-hold investor.”

Important information:

The value of investments can fall. Investors may not get back the amount invested.

381093 EXP 30 September 2021

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