Introduction
Business quality refers to a firm’s ability to sustainably generate cash flows and earn high returns on invested capital.
Some value investors focus exclusively on investing in high-quality businesses. Other value investors are less concerned about business quality, taking the mantra that “there are no bad companies, only bad prices.” This latter group of deep value investors often focuses on companies selling below liquidation value, as poor-quality businesses often inevitably end up selling off their assets and distributing the proceeds to investors.
I take a more nuanced view of business quality.
My preference is to invest in high-quality companies whose shares are trading at a favorable price. These opportunities, however, are rare. In the absence of such investments, I am willing to go a bit further down the quality spectrum if the market price is attractive enough. But I try to avoid poor-quality businesses at all costs.
Just as a high-quality company generates positive cash flow and high returns on capital, a poor-quality company often generates low-to-negative cash flows and low-to-negative returns on invested capital, often below the firm’s cost of capital. My view is that the price is seldom low enough to compensate for the destruction of shareholder value.
Thus, analyzing business quality is an indispensable component of the research process. It helps investors identify poor companies to avoid as much as it helps them identify great companies worthy of further analysis.
Competitive Advantage
A company creates value for its shareholders when its returns on capital exceed the firm’s cost of capital.
Returns on capital measure operating profits as a percentage of the capital invested in the business. The cost of capital is the blended cost of equity and debt capital. When a company earns returns above this cost, it creates value. When a company earns returns below this cost, it destroys value.
Business history shows that excess returns attract competitors, and enhanced competition often drives down excess returns. As a result, a company can only sustainably generate excess returns when it possesses a competitive advantage.
A competitive advantage is a source of differentiation that allows the firm to price its products or services at a premium to competing products or services, produce at a lower cost, retain customers more effectively, or otherwise protect its economic position from competition.
According to research firm Morningstar, competitive advantages often come from five sources:
- Intangible assets, such as brands or patents;
- Cost advantages, such as scale economies;
- High switching costs;
- Network effects; and
- Efficient scale.
These sources of competitive advantage are often referred to as economic moats because they help protect a company’s profits from competitive attack.
Intangible Assets
Intangible assets are assets that lack physical substance but possess significant economic worth.
Unlike physical assets, many intangible assets created by the firm do not appear on the balance sheet as separately recognized assets. Internally developed brands, customer relationships, reputation, organizational know-how, and similar internally generated assets may have enormous economic value, but accounting rules often require the related expenditures to be expensed rather than capitalized. As a result, investors should not assume that the balance sheet fully reflects a company’s most valuable assets.
The two most common sources of intangible competitive advantage are brands and patents.
A brand refers to the attributes, such as a name, logo, reputation, or customer perception, that specifically identify a product or service. A brand is a source of competitive advantage when consumers have favorable perceptions of the product such that they are willing to pay a premium over similar products.
Since brands are often created and enhanced by a firm’s advertising, marketing, product quality, and customer experience, investors must determine whether a firm is adequately investing in such areas. A strong brand can take decades to build but can deteriorate if management underinvests in product quality or damages customer trust.
A patent is an exclusive right granted to a firm to sell a product or use a process. Patents often provide a firm with pricing power. For example, a pharmaceutical company with a patented drug may be able to price the drug at a high markup because competitors cannot immediately offer identical substitutes.
Patents, however, eventually expire. Once a product is off patent, it will often attract competition, which can drive down the firm’s prices and profits. Investors must be careful not to forecast excess profits from a patented product beyond the patent period unless the company has other sources of competitive advantage.
Cost Advantages
A firm possesses a cost advantage when it can produce a good or service at a lower cost than its competitors. Such firms are able to generate higher volume and excess profitability by offering consumers lower prices or by maintaining prices while earning superior margins.
The two most common sources of cost advantage come from economies of scale and economies of scope.
Economies of scale refer to reduced per-unit costs arising from larger production and sales volumes. Companies with economies of scale have cost advantages over smaller rivals because fixed costs can be spread across a larger revenue base or production volume.
A retailer with significant scale, for example, may be able to negotiate better terms from suppliers, invest more efficiently in distribution infrastructure, and spread advertising costs over a larger customer base. A manufacturer with scale may be able to produce units at a lower cost because factory overhead, engineering, and procurement costs are spread across higher output.
Economies of scope refer to the spreading of production, distribution, marketing, or administrative costs over a variety of products. Economies of scope also often result from the size of the producer. A company with an established distribution network, for example, may be able to introduce additional products at a lower incremental cost than a new entrant.
Cost advantages can be powerful, but investors should determine whether they are sustainable. Temporary purchasing advantages, short-term labor cost advantages, or benefits from underinvestment are not the same as a durable cost advantage. A true cost advantage should be difficult for competitors to replicate.
High Switching Costs
Switching costs refer to the costs a customer incurs to change suppliers. These costs may be financial, operational, contractual, technological, or psychological.
When switching costs are high, a customer will be less likely to change to a competitor’s product or service even when the competitor is offering a lower price. High switching costs can therefore offer firms pricing power, provided the price differential is below the customer’s cost of switching.
Switching costs are common in business software, financial services, industrial products, healthcare systems, and other areas where customers must invest time, money, training, integration, or operational disruption to move from one supplier to another.
For investors, the key question is whether the customer is staying because the company provides superior value or because switching would be too painful. Both can create durable economics, but the first may be more attractive because it is supported by customer satisfaction rather than customer captivity alone.
Network Effects
A network effect occurs when an increase in the number of users enhances the value of a good or service.
Many e-commerce, payment, marketplace, software, and social-media companies rely on network effects to enhance consumer value. A marketplace with more buyers becomes more attractive to sellers, and a marketplace with more sellers becomes more attractive to buyers. A payment network with more merchants becomes more useful to consumers, and a payment network with more consumers becomes more useful to merchants.
Network effects can be powerful because they create a self-reinforcing loop. As the network becomes more valuable, more users join. As more users join, the network becomes even more valuable.
However, investors should distinguish between true network effects and mere scale. A company may have many users without having a durable network effect. The relevant question is whether the value of the service increases for existing users as more users join.
Efficient Scale
Efficient scale refers to instances when a small number of producers can more efficiently produce products or services for a given market.
In such markets, potential competitors are deterred from entering because doing so would lead to value destruction across the entire market. Although firms in efficient-scale markets may enjoy excess profits, their pricing power is generally limited.
Efficient scale often appears in markets where demand is limited and fixed costs are high. For example, certain local utilities, specialized infrastructure assets, and niche industrial markets may not be large enough to support many competitors. If a new entrant entered the market, the additional capacity could reduce returns for all participants.
Investors should analyze efficient scale carefully. A market may appear protected because it has few competitors, but the protection may be due to limited growth rather than exceptional profitability. Efficient scale can support durability, but it does not necessarily imply rapid growth.
Competitive Strategy
A company’s competitive strategy refers to its plan for achieving and sustaining competitive advantage.
Harvard professor Michael Porter popularized the term competitive advantage and developed a framework for analyzing the competitive forces within an industry. According to Porter, five key forces within an industry will largely determine a company’s strategy. These forces are themselves the product of an industry’s competitive landscape.
Porter’s five forces are:
- Threat of new entrants;
- Threat of substitute products;
- Bargaining power of customers;
- Bargaining power of suppliers; and
- Rivalry among existing competitors.
Each force represents a weight on a firm’s pricing, costs, or profitability. How well a company can mitigate these forces has a direct impact on the firm’s long-term profitability.
Threat of New Entrants
The ease with which potential competitors can enter an industry is a drag on that industry’s profitability.
An industry’s barriers to entry refer to the expenditures or obstacles a firm must overcome to effectively compete. These barriers may include investment in plant and equipment, technology, distribution, advertising, regulatory approval, customer relationships, scale, intellectual property, or brand recognition.
Generally, an industry with low barriers to entry will be highly competitive and therefore less profitable than industries with higher barriers to entry.
When barriers to entry are low, excess profits are unlikely to persist. Competitors will enter, capacity will increase, pricing will weaken, and returns will often decline. When barriers to entry are high, existing firms may have a better opportunity to earn attractive returns over long periods.
Investors should not merely ask whether a company is currently profitable. They should ask what prevents new competitors from entering and competing those profits away.
Threat of Substitute Products
When consumers can easily substitute one product for another, they will be unwilling to pay significantly higher prices for the product.
Thus, the existence of substitute products represents a limit to profitability. The threat of substitution is high when alternative products or services exist that perform effectively the same function and the consumer can switch to these alternatives without incurring significant costs.
Substitution risk can be subtle. The substitute does not need to be identical. It only needs to solve the customer’s problem in a sufficiently comparable way. A company may dominate its narrow product category but still face pressure from a broader alternative that changes customer behavior.
Investors should look beyond direct competitors and consider the customer’s underlying need. The question is not merely, “Who sells the same product?” The better question is, “What else can the customer use to accomplish the same objective?”
Bargaining Power of Customers
Customers with substantial purchasing power can influence an industry’s prices.
When large buyers are few and potential suppliers are plentiful, a supplier’s profits will suffer. In retail, for example, large retailers can use their buying power to extract price concessions from suppliers.
Customer bargaining power is especially important when customers purchase in large volumes, when the product is undifferentiated, when switching costs are low, or when customers can credibly threaten to produce the product themselves.
For investors, customer concentration is an important warning sign. A company that depends heavily on a small number of customers may report strong current profitability but have a fragile competitive position. If one customer can demand lower prices, change suppliers, or delay purchases, the company’s economics may be weaker than they appear.
Bargaining Power of Suppliers
A firm that has a small number of suppliers will generally face higher input costs than a firm operating in an industry with a greater number of suppliers.
In other words, in an industry with few suppliers, those suppliers may capture a greater proportion of the industry’s profits.
Supplier bargaining power is high when the supplier provides a critical input, when there are few substitute inputs, when switching suppliers would be costly, or when the supplier’s product represents a relatively small but essential part of the customer’s total cost structure.
Investors should analyze whether a company can pass higher input costs on to customers. A company with pricing power may be able to protect margins when suppliers raise prices. A company without pricing power may see margins compressed.
Rivalry Among Existing Competitors
In mature markets with largely undifferentiated products, competitors may attempt to gain market share through aggressive price cutting or other means.
In capital-intensive industries, firms may be tempted to cut prices during slow periods to keep capacity full. Such rivalry limits industry profitability.
Rivalry is generally more intense when products are undifferentiated, fixed costs are high, growth is slow, exit barriers are high, or competitors are numerous and similarly situated. Industries with intense rivalry may appear attractive during strong periods but can quickly become unattractive when demand weakens.
Investors should be cautious when analyzing companies in highly competitive industries. Even well-managed companies may struggle to earn attractive returns if the structure of the industry works against them.
Business Quality Metrics
The two most useful metrics for assessing business quality are free cash flow and return on invested capital, or ROIC.
These two metrics are often the analytical starting point for investors. Once an investor has identified a company with significant free cash flow and attractive ROIC, the investor can then analyze the sustainability of these metrics using the competitive advantage and competitive strategy frameworks discussed above.
A high current ROIC is not enough. A high current free cash flow yield is not enough. Investors must ask whether the business can continue to generate attractive results and whether competition, regulation, technological change, customer behavior, or management decisions are likely to impair those results.
Free Cash Flow
Free cash flow represents the residual cash generated during a period that is available for discretionary uses, such as debt repayment, dividends, share repurchases, and investments in growth.
Since free cash flow, unlike accounting earnings, represents a company’s residual cash generation, many investors consider free cash flow to be the lifeblood of shareholder value creation.
Investors often calculate free cash flow by adding depreciation and amortization to operating income and then subtracting the company’s investments in property, plant, equipment, and working capital. Analysts may adjust this calculation depending on the company, industry, and purpose of the analysis.
Firms that possess a competitive advantage, and thus pricing power or cost advantages, will often generate significant free cash flow that management can allocate on behalf of shareholders.
The quality of free cash flow matters as much as the amount. Investors should determine whether free cash flow is recurring, whether it depends on temporary reductions in working capital, whether maintenance capital expenditures are being understated, and whether reported earnings are converting into cash.
Return on Invested Capital
Investors view operating profit in relation to the invested capital needed to support it.
A company that generates operating profits equal to 5% of invested capital is inferior to a company that earns operating profits equal to 20% of invested capital, assuming the risks and reinvestment opportunities are otherwise comparable.
To calculate return on invested capital, investors divide net operating profits after taxes, or NOPAT, by invested capital. Investors calculate NOPAT by multiplying the company’s earnings before interest and taxes, or EBIT, by one minus the firm’s tax rate.
NOPAT = EBIT × (1 – Tax Rate)
ROIC = NOPAT ÷ Invested Capital
This method of calculation allows investors to compare the operating performance of companies with different capital structures. Because NOPAT is calculated before interest expense, it focuses on the profitability of the business operations rather than the effects of financing decisions.
Invested capital can be calculated in different ways, but it generally represents the capital required to operate the business. One common approach is to use working capital plus net fixed assets and other operating assets, less non-interest-bearing operating liabilities. The specific calculation should be applied consistently and adjusted when necessary to reflect the economics of the business.
The concept of ROIC highlights an important economic principle: companies that invest in projects or acquisitions that earn low returns on invested capital destroy shareholder value.
The rule is as follows: firms create shareholder value when they invest in projects that earn ROIC above the firm’s cost of capital, which is the proportional average of its debt and equity costs. When companies cannot find attractive investment opportunities, they should return cash flow to shareholders through share repurchases or dividends.
ROIC is especially useful because it connects the income statement to the balance sheet. It forces the investor to ask not only how much profit a company earns, but how much capital is required to earn that profit.
Management and Capital Allocation
Business quality is not determined solely by industry structure or current financial metrics. Management’s capital allocation decisions can either compound the advantages of a high-quality business or squander them.
A business that generates free cash flow gives management choices. Management can reinvest in the business, acquire other companies, reduce debt, repurchase shares, or pay dividends. These decisions matter.
A high-quality business can become less valuable if management allocates capital to low-return acquisitions or reinvests in projects that earn less than the cost of capital. Conversely, disciplined management can enhance shareholder value by reinvesting only when returns are attractive and returning excess capital when opportunities are limited.
Investors should therefore analyze not only the quality of the business, but also the quality of management’s capital allocation record.
Conclusion
A high-quality business is a business that possesses a durable competitive advantage.
This competitive advantage allows the firm to generate significant free cash flow and high returns on invested capital. By using the competitive advantage and competitive strategy frameworks, investors can focus their analytical efforts on the drivers of shareholder wealth.
Business quality analysis does not eliminate the need for valuation. Even a great business can be a poor investment if the market price is too high. But understanding business quality helps investors judge the durability of cash flows, the sustainability of returns, and the likelihood that a company can continue creating value over time.
For value investors, the objective is not merely to find statistically cheap securities. The objective is to understand the relationship between price, business quality, and intrinsic value.
Sources
Brilliant, Heather, and Elizabeth Collins. Why Moats Matter: The Morningstar Approach to Stock Investing. Hoboken: Wiley, 2014.
Koller, Tim, Richard Dobbs, and Bill Huyett. Value: The Four Cornerstones of Corporate Finance. Hoboken: Wiley, 2011.
Porter, Michael. “The Five Competitive Forces That Shape Strategy.” Harvard Business Review, January 2008.
Thorndike, William N. The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint to Success. Boston: Harvard Business Review Press, 2012.
