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Quality over quantity: a lesson of value

There are, broadly speaking, two kinds of stock market investors in this world: those who believe they can beat the market; and those who don’t. The latter group of investors tends to buy index-style funds that hold very small shares of nearly every company out there which ensures the delivery of the market return, net of fees, with little deviation.

But what about the former group of investors?  One philosophy which has demonstrated sustainable outperformance of the market over long periods of time is that of “value investing.” Under this philosophy, the investor will hold shares in relatively fewer companies, which are of relatively higher quality and purchased at relatively lower valuations.

While many subscribe to these ideas, putting them into practice is not a trivial task. One area that many investors grapple with is articulating precisely what constitutes a “high quality” business. One way to think about the quality of a business is to answer the following question: how easy would it be for a competitor to recreate the business? If the answer is “very easy” – as would be the case for, say, a corner store, then the quality of the business is low. On the other hand, if the answer is “very difficult, time consuming or costly” – as is the case for, say, Facebook, then the quality of the business is high.

When thinking about how to answer this question, one can think of three key sources of quality. A business can be qualitatively evaluated for these elements of quality with a check-list type approach. The three sources of quality are: economies of scale, customer captivity and government protection, such as license or patents.

Economies of scale relate to the dynamic of bigger businesses exhibiting a cost advantage over smaller customers. When fixed costs can be spread across a relatively larger quantity of goods and services, average unit costs are relatively lower. Furthermore, bigger businesses can exhibit stronger bargaining power over suppliers and drive more favorable terms than smaller businesses. We are seeing this dynamic all too clearly in the Australian supermarkets space.

Customer captivity relates to the ease with which customers can switch to a competitor. A business that has a large degree of customer captivity is often more successful in pushing through higher prices. There are various forms of customer captivity. These include integrated systems between the business and its customers, as is the case for Visa and Mastercard; as well as customer loyalty programs that effectively increase the cost for customers to switch.

Finally, when a business has privileged access to resources or a patent, this represents an advantage that cannot easily be recreated by competitors.  For instance, one of the reasons why BHP is such a world-class business is because it has government-protected rights to mine the natural resources of Australia and other nations. Without these rights, the company’s quality would be severely impaired. Patents on new technology create a similar degree of quality to the extent they are protected by the government.

Value investors will aim to hold portfolios of shares in companies that exhibit many of the elements described above. As long as the investor does not overpay for these businesses initially, they can be reasonably assured of market outperformance over long periods of time. These principles of value investing are worth keeping in mind for both individual investors as well as those looking to evaluate the investment managers of externally-managed funds.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!