“Another commonly used decisional shortcut (which psychologists call ‘heuristics’) is to classify various phenomena into two opposing camps. Rarely will we qualify things or people with a shade of grey when, it is this colour that characterizes most phenomena.
A simplistic categorization is to classify companies into the three camps of ‘small-, mid- or large-cap’ stocks.
I believe that if an investor were to categorize the securities of companies in his investment universe, he should do so as follows:
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- Poor quality stocks;
- Stocks of acceptable quality;
- Top-quality stocks.”
I could have used the adjectives “Exceptional, Enviable or Terrible”; it’s more poetic.
Of course, not everything is so clean and precise. We can debate for a long time before placing a company in a category. Furthermore, things change over time and an exceptional company can become rather ordinary over years or decades. I wouldn’t say any company is terrible, but maybe once great companies like GE or Intel are.
My role as Chief Investment Officer at COTE 100 is to increase the number of exceptional companies we hold in our portfolios under management. In an ideal world, all our companies would be. But a perfect world does not exist.
To help you in your work of categorizing the quality of a company, let’s see the main characteristics of each of the three categories.
The Exceptional
An exceptional company obtains a high return on its invested capital and can reinvest its profits to obtain high rates of return. Also, its business model is protected by high barriers to entry which allow it to persist and maintain high profitability. These barriers to entry act like a moat that prevents competitors from “penetrating” a company’s economic castle.
There are multiple barriers to entry. They include a recognized brand, low costs linked to strong economies of scale, an unrivalled and difficult to replicate distribution network, patent protection, regulation of an industry, the need to invest enormous capital, etc.
Ideally, the business model of such a company requires little capital to continue its growth. On the other hand, there are many attractive investment opportunities, and its industry is driven by positive natural growth.
These companies are by definition exceptional and therefore very rare. I think investors can count themselves lucky to have a handful of them in their portfolio. If you own such a company, it is important to keep it as long as possible.
Some examples: Apple, Microsoft, Copart, Visa, Costco.
The Enviable
There are more companies that I would call “enviable”. They are profitable, even very profitable, and obtain a high return on their capital. This return is, however, lower than that of exceptional companies: let’s say between 10% and 15% compared to the 15% and more for exceptional companies.
These companies have undeniable competitive advantages, but the barriers to entry are lower and competition is more present than for exceptional companies.
Often, such companies are forced to reinvest significant sums in an attempt to maintain their competitive position and their level of profitability.
There is nothing wrong with owning such stocks in a portfolio. Often, these companies will provide us with good long-term returns, although they will be significantly lower than those of exceptional companies. Also, these companies will require closer monitoring because their commercial and financial success could decline and possibly be reversed.
Examples: Quincaillerie Richelieu, CGI, Fiserv.
The Terrible
An investor should avoid these companies at all costs. They are generally not very profitable, if at all. While they make profits, their return on invested capital is anemic (less than 10%) and often lower than their cost of capital.
These companies typically have a regular need for external capital to finance their growth and their balance sheet often displays a high level of debt.
In addition, these companies operate in sectors where competition is fierce and barriers to entry are almost non-existent.
Examples: Transat, Air Canada, GE.
Price Paid
Once you get to know some exceptional companies, it is quite easy to identify others. But as I said, these companies are extremely rare; this is why their stocks most of the time trade at very high valuation levels.
However, sometimes, for whatever reason, the stock of such a company corrects on the stock market and trades at a reasonable valuation. This is then a golden opportunity to invest.
As for the price paid, I have learned over time that you have to be prepared to pay more for high-quality companies. As for so-called enviable companies, I believe that you have to buy their shares at very attractive valuation ratios if you want to get attractive returns over the years. When it comes to stocks of terrible companies, no price would be low enough to attract us.
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Philippe Le Blanc’s Blog is published in
