Quality Investing

Owning the best companies for the long term

Lawrence A. Cunningham, Torkell T. Eide

• Publisher: Harriman House
• Year: 2016
• eBook ISBN: 9780857195012
• Edition: 1

Quality. We all make judgments about it every day. Yet articulating a clear definition of quality in an investing context is challenging. This book addresses the challenge, and distills years of practical investing experience into a definitive account of this under-explored investment philosophy.Finance theory has it that abnormal outcomes do not persist, that exceptional performance will soon enough become average performance. Quality investing involves seeking companies with the right attributes to overcome these forces of mean reversion and, crucially, owning these outstanding companies for the long term. This book pinpoints and explains the characteristics that increase the probability of a company prospering over time - as well as those that hinder such chances. Throughout, a series of fascinating real-life case studies illustrate the traits that signify quality, as well as some that flatter to deceive.The authors' firm, AKO Capital, has a strong track record of finding and investing in quality companies - helping it deliver a compound annual growth rate more than double that of the market since inception. Quality Investing sheds light on the investment philosophy, processes and tough lessons that have contributed to this consistent outperformance.

Chapter One Building Blocks

For the past 20 years, organic sales growth at French cosmetics giant L’Oréal has been phenomenally consistent, averaging over 6% with only one year of contraction, in 2009. The company has maintained a strong post-tax return on capital, which has gradually increased from the mid to high teens over the same period. Its cash conversion track-record has also been consistently strong.

Although L’Oréal’s organic growth rates would not qualify it as a ‘growth’ stock, this combination of traits has driven extraordinary long-term results. L’Oréal’s earnings growth has compounded by 11% over this 20-year period, and the stock price has increased over 1,000%, outperforming the broader market nearly five-fold in the process.

Stellar shareholder returns largely reflect the virtuous circle of L’Oréal’s sustained cash generation and effective cash deployment. The company has invested heavily in both research and development (R&D) as well as marketing and promotion, and has acquired a number of new brands, the returns on which have been attractive. Excess capital has been diverted into paying a steadily increasing dividend and reducing its shares outstanding by more than 10% through buybacks.

L’Oréal exemplifies the benefits that can accrue from the combination of a supportive industry structure, a management team willing to invest in growth, a differentiated product offering and a unique set of competitive advantages. These factors are what have enabled the company to deliver long-term financial success and to take advantage of its attractive set of growth opportunities. In other words, these are the building blocks of a quality company. They are crucial to the delivery and sustainability of the attractive financial traits we seek.

This chapter discusses each of these important financial and non-financial building blocks in turn. We start with a discussion of return on capital and growth, before looking at how management teams can affect a company’s prospects. Finally, we delve into the ways different industry structures, customer benefits and competitive advantages can affect an assessment of quality.

A. Capital Allocation

A company can choose to allocate capital in one of four main ways: capital expenditures for growth; advertising and promotion or R&D; mergers and acquisitions; or distributions to shareholders through dividends or share buybacks. We review each of these in turn, as well as briefly considering working capital, an underappreciated aspect of capital deployment. These capital allocation decisions are some of the most critical a company makes, and are the difference between creating value and destroying it.

Growth capex

Companies typically refer to all internal investments as capital expenditures, but there is an important distinction between capital expenditures required for maintenance and those incurred for growth or expansion. Unlike growth capital expenditures, maintenance capital expenditures are required just to maintain the status quo. This form of capital outlay is therefore equivalent to ordinary operating expenses and should be relatively predictable. Growth capex, as the term suggests, is the deployment of capital for the purposes of generating organic growth. Examples might include the construction of a new plant to increase production capacity, or investment in new stores for a leisure or retail concept.

Today, Swedish fashion retailer H&M operates from more than 3,500 stores globally, up from less than 1,200 in 2005. In 2014, the company opened the equivalent of more than one outlet every day. Despite relatively modest like-for-like sales growth (averaging a shade above 1% for the last ten years), H&M’s solid returns on its new store investment, even adjusted for leases, have enabled the group to more than double per-share earnings over this period. Such performance in capital allocation is laudable. Sustaining high returns on incremental organic capex in this way yields significant compound growth, making it our preferred use of capital where the right investment opportunities exist.

Investment in R&D and advertising and promotion (A&P)

Today’s impressive sales of Dove soap, made by Unilever, result largely from decades of historical marketing spending to build the brand. By creating brand awareness, Unilever invested, in effect, in the consumer’s consciousness. It bought a mental barrier to entry, as rivals would need to spend substantial sums to replace the brand in the minds of consumers. While ongoing brand advertising is needed to sustain awareness – an outlay best seen as equivalent to maintenance capital expenditures – a large portion is aimed at influencing new generations of consumers. This is more comparable to growth capex.

In many industries, spending on advertising is an important launch pad for a company’s competitive advantage and future growth. While some advertising efforts drive current sales, such as in-store exhibits, the real value accrues from sustained campaigns aimed at brand building. Unlike constructing factories or buying equipment, brand spending creates no tangible asset that can be appraised and depreciated. From a financial viewpoint, it is money out the door just as much as rent and rates. Unlike many other cost items, however, it can create lasting value.

So while financial statements classify advertising costs as expenses, they are often better conceived of as investments. This reclassification makes sense because advertising is also a far more flexible expenditure than most costs. Amid challenging economic times, advertising can be scaled back relatively quickly, adding agility to protect and manage cash flows. However, paring back too far, or for too long, can lead to long-term value erosion.

R&D costs are similar to advertising. While contemporary accounting rules allow companies to treat some R&D disbursements more like long-term assets, we focus explicitly on their dual nature: some are properly seen as expenses necessary to maintain a business, while others, the vastly larger proportion, are best viewed as investments in future growth.

Measuring returns on R&D and advertising outlay can be challenging. For R&D, in particular, there are many industries where a return will not be recovered for many years. Appropriately capitalizing these expenses is a start, but a company’s long-term track record of generating returns on its R&D outlay is often the best indicator of R&D efficiency.

Mergers and acquisitions

Acquisitions are a common source of value destruction, so it is usually better for capital to be deployed on organic growth as opposed to M&A. That said, there are a few contexts in which acquisitions can create value for shareholders. Consolidation of fragmented industries is often an appealing rationale for growth through acquisitions. Such roll-ups, as they are often called, do not invariably succeed,6 but there are several notable examples of successes.

For example, Essilor, a global leader in making lenses for eyeglasses, has a long history of small bolt-on acquisitions. Individually insignificant, these have become material in aggregate, adding more than 3% in annual sales per year for the last decade. These purchases are most commonly of local optical labs that give Essilor access to a local customer base and better control of its value chain. Pre-acquisition, Essilor might represent 40% of a lab’s lens sales, whereas after closing, it would double that level. Given the specialized niche and deal size, there is scant competition in this acquisition market, enabling Essilor to purchase companies on attractive terms (such as six to seven times cash flow). This ability to systematically improve the operations of acquired businesses is rare but can create significant value.

Another strategy that can yield good outcomes is buying a business that is already strong. A paradigm occurred in 2007 in the eyewear market, when Luxottica, an established business offering a variety of products including sports eyewear, acquired Oakley, an already successful brand entirely focused on sports eyewear. While operations remain largely autonomous, Luxottica multiplied Oakley’s distribution channels and created crossover branding to other premium fashion products, including women’s wear.

We estimate that Oakley’s sales growth has increased by 10% per annum under Luxottica’s ownership, double the market rate during the period, and that margins have meaningfully increased. During this time, Oakley has cemented its position as an iconic sunglass brand, expanded its optical presence, and helped to enhance Luxottica’s dominance in the premium eyewear industry. While we are generally skeptical of mergers rationalized on the basis of over-optimistic and loosely defined synergies,7 certain sub-sectors do offer opportunities for mutual benefits from bringing two good businesses under one roof.

Leveraging network benefits – such as a larger or more comprehensive distribution network – is another common characteristic of successful acquisitions. One excellent example of a company that does this effectively is Diageo, the consumer goods company with a portfolio of world-famous beverages. Often, Diageo’s acquisitions not only add good but under-penetrated brands to the global portfolio – such as Zacapa rum, now part of its Reserve line; they also improve distribution into new markets for existing brands. Recently acquired brands from deals such as Mey Icki in Turkey and Ypióca in Brazil are now sold elsewhere and, more importantly, Diageo’s existing brands are now selling better in both those countries.

ASSA ABLOY: Quality Deals

ASSA ABLOY, the global leader in locks and door opening solutions, commands brands and businesses dating back four centuries. The Chubb brand, for example, was founded in 1818 in Wolverhampton, England and served a prestigious clientele that included the Duke of Wellington, the Bank of England, and the General Post Office for installation in all the country’s iconic red Royal Mail boxes. The product of a merger in 1994, ASSA was founded in 1881 in Eskilstuna, Sweden and ABLOY in 1907 in Helsinki, Finland. Mergers and acquisitions have been a vital part of ASSA ABLOY’s continued growth ever since.

During the late 1990s and early 2000s, ASSA ABLOY was a prodigious deal-maker as it consolidated a fragmented market. Since 2006, under the leadership of CEO Johan Molin, it has made over 120 acquisitions, primarily to expand geographical distribution and secondarily to deepen technological sophistication. During that period, the company added 8% annually to revenue so that today, nearly half the group’s total revenue flows from businesses acquired under Mr. Molin. At the time of acquisition, businesses typically had lower operating margins, by as much as five percentage points. On integration, margins rose. Everything else being equal, acquisitions would have diluted group operating margins meaningfully, from 15% in 2006. Thanks to strategic savvy and exploiting synergies, margins instead rose to more than 16% in 2014.

In one illustrative acquisition, among the biggest, ASSA ABLOY in 2002 acquired Besam, the world leader in automated door systems. Until then, ASSA ABLOY lacked a substantial presence in that segment, but the company went on to make Besam the foundation of an even wider division dubbed Entrance Systems. ...

Table of contents

• Contents
• Preface
• Chapter One 
Building Blocks
• Chapter Two 
Patterns
• Chapter Three 
Pitfalls
• Chapter Four 
Implementation