Investing is a game of skill, patience, and strategy. One strategy that stands out for its potential to deliver exceptional returns over the long term is quality investing. Quality investing focuses on identifying and investing in companies that exhibit strong fundamentals and sustainable competitive advantages. These companies, often referred to as "compounders," have the ability to grow their free cash flow exponentially over time, creating wealth for their shareholders. What makes quality investing particularly attractive is its buy-and-hold approach, allowing investors to benefit from the power of compounding.
Quality vs value
Quality investing is often confused with value investing, another popular investment strategy. Value investing involves identifying undervalued companies whose stock prices are trading below their intrinsic value. The goal of value investing is to buy these undervalued stocks and sell them once they reach their fair value, often based on a calculated intrinsic value. This approach requires active monitoring and periodic buying and selling of stocks.
In contrast, quality investing focuses on investing in companies that are already considered high-quality and are expected to continue performing well in the future. Instead of looking for undervalued stocks, quality investors seek out companies with strong competitive advantages, solid management teams, and a history of consistent growth. Once identified, these companies are held for the long term, allowing investors to benefit from their continued success and growth.
The most famous quality investor, often mistaken for a value investor, is Warren Buffett. This is why he famously said that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
The power of compounders
The key to successful quality investing lies in identifying and investing in compounders—companies that can grow their free cash flow consistently and exponentially over time. These companies typically exhibit a combination of favorable characteristics that contribute to their long-term success. Once you have done your homework and invested in a quality company, you can sit back and let the company work for you, compounding your investment over time.
Examples
Some notable examples of long-term compounders include IDEXX Laboratories (CAGR of 21.2% since 1991), Microsoft (CAGR of 25.9% since 1986), and Pool Corporation (CAGR of 26.3% since 1995). These companies have demonstrated the ability to grow their free cash flow consistently over the years, making them attractive investments for quality investors.
Terry Smith's approach to quality investing
Terry Smith, founder of Fundsmith and often referred to as
"the English Warren Buffett", has outlined three key metrics for quality investing:
- Buy good companies.
- Don't overpay.
- Do nothing.
This simple yet effective approach emphasizes the importance of investing in high-quality companies at reasonable prices and then holding onto them for the long term, allowing the power of compounding to work its magic.
Identifying quality companies
The million-dollar question for quality investors is how to find these quality companies. Quality companies often exhibit the following characteristics, which we will explore in detail:
- A wide moat (competitive advantage)
- Integer management (skin in the game)
- Low capital intensity
- Good capital allocation
- High profitability
- Attractive historical growth
- A secular trend (bright outlook)
Wide moat
A wide moat refers to a company's sustainable competitive advantage that allows it to maintain its market dominance and pricing power over time. Investing in companies with wide moats means investing in market leaders that have already established their superiority in their respective industries. Examples of companies with wide moats include S&P Global, Moody's, Nike, Adidas, Visa, Mastercard, Assa Abloy, MSCI, and Equifax.
Integer management
Integer management refers to management teams that have a significant personal stake in the company, aligning their interests with those of shareholders. Companies with integer management are often family-owned businesses, which have been shown to outperform non-family businesses. Examples of quality family-run businesses include LVMH, L'Oréal, Kone, Copart, and Stryker.
Low capital intensity
Low capital intensity refers to companies that require minimal capital investment to maintain and grow their businesses. These companies can generate high returns on invested capital (ROIC) and are efficient at deploying their capital to generate sales growth. Examples of low capital intensity businesses include Automatic Data Processing, Domino's Pizza, and Blackrock.
Great capital allocation
Great capital allocation refers to how effectively a company uses its cash flow. Companies that reinvest their cash flow in high-return opportunities, such as organic growth initiatives or strategic acquisitions, tend to be better long-term investments. Examples of companies with great capital allocation metrics include Sherwin-Williams, Pool Corporation, and Adobe.
High profitability
High profitability is a key characteristic of quality companies. Companies with high profitability margins and strong free cash flow generation are better positioned to withstand economic downturns and invest in future growth opportunities. Examples of companies with high profitability margins include IDEXX, Ansys, Johnson & Johnson, and Fortinet.
Secular trend
Investing in companies that are part of a strong secular trend can provide long-term growth opportunities. Secular trends, such as urbanization, cybersecurity, datacenters, semiconductors, hearing aids, and obesity, can drive sustained growth for companies operating in these industries. Examples of companies in strong secular trends include Novo Nordisk, Kone, Fortinet, Blackrock, and Sonova.
Valuation
While the quality of the business is paramount in quality investing, valuation still plays a role. It's important not to overpay for quality companies, as this can impact future returns. The goal is to buy quality companies at fair prices, ensuring a margin of safety in the investment.
Conclusion
Quality investing is a strategy that focuses on identifying and investing in high-quality companies with strong fundamentals and sustainable competitive advantages. By holding onto these companies for the long term, investors can benefit from the power of compounding and achieve significant returns. The key is to identify companies with wide moats, integer management, low capital intensity, good capital allocation, high profitability, attractive historical growth, and a strong secular trend, and to buy them at fair valuations. With patience and a long-term perspective, quality investing can be a rewarding strategy for investors seeking sustainable wealth creation.