But how do you know if a business is of high quality? The quality of a business is subjective and depends on the perspective of each investor. However, let me introduce you to the factors that make for a high-quality business for me. You are free to incorporate some of them into your evaluation criteria.
1. The sustainability of the business model. For the long-term investor, the sustainability of companies is of paramount importance. We seek to invest in companies that can achieve a high return on their capital for many years.
However, to aspire to this, it is preferable that a company’s business model is protected by sustainable competitive advantages that will act as a sort of barrier to entry for potential competitors. Such barriers can come from a recognized trademark, low operating costs resulting from economies of scale, protection created by regulation or by patents, by the network effect, high switching costs, etc.
I also favour companies whose activities are not subject to major technological changes (if there are any!). As much as possible, I look for companies whose products or services are essential and sustainable.
2. A high return on capital. There are generally two ways for a business to achieve a high return on capital: earning a high after-tax profit margin or by “turning over” their capital or assets quickly. A company like Pfizer achieves a high return on capital with a high profit margin, while a company like Costco achieves the same feat with a high turnover of its assets. For our part, we prefer companies that require little capital and can grow quickly without having to invest large sums in fixed assets.
3. A significant potential market. To grow for many years, a business will need to address a market that is large or one that will experience significant growth for many years. A company must also have demonstrated its ability to innovate by reinvesting its profits in attractive growth projects.
4. A solid management team. I will refer you here to a series of blogs on this subject.
Basically, I’m looking for companies whose leaders have a long track record of creating value for their shareholders and who, ideally, are significant shareholders of the company they run.
These, in my opinion, are the four main factors that determine the quality of a business. As I wrote in my previous blog, I believe that investors who focus exclusively on high quality securities significantly increase their margin of safety over the long term.
