• Eugen Neagu

Why quality investing?

Updated: Jan 21

Stronger portfolio design leads to better outcomes for investors. At N2 Asset Management Limited we have kept the same principles and structure that made our investment proposition so successful in the past. We are optimistic about the future, and we believe that the whole equity market will continue to deliver long term value as it has always done. In short, we believe capitalism works.

Our equity exposure gives a high allocation to what is known as quality companies. This may sound blindingly obvious, but you might be surprised to know how many investors fail to have a good definition of a high-quality business.

A high-quality company is a company which has two main qualities: a high Return on Capital Employed (ROCE), and high barriers to entry (Warren Buffett calls them ‘moats’) to protect the high ROCE.

It is important to note that we are not just looking for a high rate of return but also a sustainably high rate of return. An important contributor to this is repeat business, usually from consumers. A company that sells many small items each day is better able to earn more consistent returns over the years than a company whose business is cyclical, like a steel manufacturer, or a property developer, which only gets paid when they are able to sell a property.

This approach rules out most businesses that do not sell direct to consumers or make goods which are not consumed at short and regular intervals. Capital goods companies sell to businesses; however, business buyers could defer purchases of such products when the business cycle turns down. Moreover, businesses employ staff specialised in acquisitions, whose main job is to drive down the cost of purchase and lengthen their payment terms. Even when a company sells to consumers, it is unlikely to fit our criteria if its products have a life which can be extended. When consumers hit hard times, they can defer replacing their cars, houses and appliances, but not food and toiletries.

Quality companies do something very unusual: they break the rule of mean reversion that states investment return must revert to the average as new capital is attracted to business activities earning super-normal returns.

They can do this because their most important assets are not physical assets, which can be replicated by anyone with access to capital, but intangible assets, which can be very difficult to replicate, no matter how much capital a competitor is willing to spend. Moreover, it is hard for companies to replicate these intangible assets using borrowed funds, as banks tend to favour the (often illusory) comfort of tangible collateral for their loans. This means that the business does not suffer from economically irrational competitors, even when credit is freely available.

It is not enough for companies to earn a high rate of return. High-quality companies must also be able to reinvest a portion of their excess cash flow back into the business to grow while generating a high return on the cash reinvested. Over time, this should compound shareholders’ wealth by generating more than a pound of stock market value for each pound reinvested.

An important contributor to their resilience is a resistance to product obsolescence. This means that high quality companies will not be found in industries which are subject to rapid technological innovation. Innovation is often sought by investors but does not always produce lasting value for them. Developments such as canals, railroads, aviation, microchips and the internet have transformed industries and people’s lives. They have created value for some investors, but a lot of capital gets destroyed for others.

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Above you will see examples of high-quality companies from the consumer staples sector. Our clients tend to have exposure to Pepsico, Nestle, Coca Cola, Unilever, Mondelez, and Johnson & Johnson through the funds we choose for them. You would expect that at least 20% to 30% of the equity portfolio to be made from consumer staples stocks. Alcohol producers like Diageo, Heineken, Brown Forman (Jack Daniel’s producer) or the Chinese Kweichow Moutai are also high-quality companies, benefiting as well from the short and regular interval their clients drink their products.

There are high-quality companies outside of consumer staples sector, however they keep the same characteristics: goods and services which are consumed at short and regular interval. The advent of Software as a Service (SaaS) made Microsoft, Adobe, and Intuit high-quality companies. Facebook, although a free service is used regularly by consumers, and has high barriers to entry, and it is a high-quality company.

What can the investor expect by investing in high quality stocks? Charlie Munger once said: Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 30 years and you hold it for that 30 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 30 years, even if you pay an expensive looking price, you'll end up with a fine result.”

In fact, if you check Terry Smith’s Fundsmith Equity fund, it has returned 18% per annum from the launch of the fund 10 years ago. Our target is 15% per annum after fees over a long-term period, or about 5% outperformance on top of the MSCI World index Total Return, which has a 10% per annum expected return.

IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested