August 2019: Characteristics of a high quality company

Equity markets went through a bullish phase between 2013 and 2017, but have been on a sticky wicket since Dec-2017. Nearly a third of the stocks traded on the NSE are down more than 50% from their 2 year highs. The latest quarterly GDP growth print of 5% is a cause for concern. Over the past several years, investors have rarely questioned the continuity of India’s GDP growth potential, at over 7% pa. In recent times, some experts are beginning to suggest that there are structural issues with the Indian economy which are affecting economic growth. Another point of view is that this is a cyclical slowdown which has got extended because of the recognition of long due NPAs.

We have reiterated several times in the past that we invest in high quality companies. A high quality, or an investment grade company, in our opinion is as a first cut, highly profitable when measured on return on equity. Moreover, this profitability should be demonstrated over a business cycle. In essence, we don’t like fair weather friends. We are reluctant to believe in turn-around situations, unless the company has a very consistent track record of delivering profitability, in the past.

Further, the company, should, in our judgement, have a very high probability of survival over the long term. The market accords higher valuations to companies where the market in its wisdom believes that the company is going to be around 20 years or more from now. When you consider that the intrinsic value of a business is the sum total of all the cash that you can get out of the business in the future, discounted to today, you realize that the longer the business exists into the future, the higher should be its value. Long term survival is therefore an essential quality in any company that one wishes to invest in. However, survival by itself is not enough. It must be accompanied by a reasonable amount of growth and we look at the nominal GDP growth as a benchmark. The higher the sustainable growth of a company above the nominal GDP growth rate, the more valuable that company would be. If we have to choose, we think that profitability trumps growth. A company that is growing tremendously but not making profits, does not represent value, in our opinion, while a company that is profitable though growing slowly, is yet an investment worth considering.

Another characteristic that accompanies high quality companies is that they are asset light and generate large free cash flows. As such, these companies are light, on both fixed assets as well as working capital. What allows for profitability and free cash flows to sustain over the future is competitive edge or “moat” of the business. This could come from a variety of factors including low cost advantage, economies of scale, a technological edge, a brand, switching costs, network effects, etc.

So it’s a whole composite really, in terms of the characteristics that one is looking for, to invest in a company. Moreover, there is an element of judgement involved in making this call about the business, factoring in all that we have enumerated above, and therefore it is important for investors to stick to their ‘circle of competence” ie businesses that they understand well. Last, but not the least, it is not only important to buy a high quality company, it is equally important that you pay a reasonable price for it because the long term return that you can expect from a stock is inextricably linked to the price you pay for it.