What Is A Quality Business?

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Nearly every active manager professes to invest in quality businesses — The definition of  quality is frequently undefined or all encompassing — We adhere to a simple, but strict, definition of quality when constructing our portfolios.

What Is Quality?

Without a strict definition, “Quality” can be found everywhere—high margins, large TAM, exceptional management,  moats, networks, barriers, brands...few investors admit owning low quality stocks yet all stocks are owned. We implement a strict definition of quality as, in the words of Benjamin Graham, “Where an intermediate stand is taken the result is usually confusion, clouded thinking, and self-deception.”[1]

We define quality businesses as those capable of generating excess returns over a business cycle specifically due to a lack of competition in their industry.

Competition First

Theoretically, any business earning excess returns will face increasing competition. Competition’s purpose is to eliminate excess return, ultimately eroding outperformance and leaving behind an ordinary business. In reality, no market is perfectly efficient, and competition occasionally fails, leaving persistent excess return available to investors. We find businesses capable of generating excess return by looking for companies with little or no competition. Only these businesses can provide sustainable excess returns for our long-term hold periods.

Monopolies are of course illegal, so our daily efforts are spent attempting to understand and identify competitive vacuums that exist outside of true monopoly designations. We have found three key business and industry attributes that we believe result in limited competition and the possibility for persistent excess returns.

Competitive Dominance, or Indifference

Companies with very high relative market share tend to dominate their industries. We use this metric, typically searching for businesses at least three times the size of their largest competitor. At this massive relative scale, customers hardly have a choice in purchasing from the leading player. In addition, the scale results in a margin advantage due to efficiencies in purchasing, manufacturing, and overhead. This margin advantage leads to excess return that competitors are unable to compete away.

We also search for disciplined duopoly or oligopoly market structures. Two or three large players in consolidated markets, frequently led by business school graduates who have learned game theory, occasionally (implicitly) decide to not compete. In these scenarios the “tit for tat” game theory strategy discourages any market share changes or price actions that could threaten existing excess returns. Simply identifying this market structure can be enough to satisfy our definition of quality.

Finally, we look deep within businesses to find companies that attract the best talent. With the best talent these businesses can offer their customers the best product or service, often at a premium price. The true differentiation though is that the best talent will work for a lower cost due to the intangible rewards of working with other talented individuals! The combination of the best product combined with this cost advantage results in excess return.

The Rest of the Philosophy

Finding high quality businesses is only part of our philosophy. Ultimately, we wait for these businesses to trade at prices that will allow for double-digit annual investment returns. In addition, we require confidence that management and the capital structures of these businesses are appropriately placed to deliver the value we’ve identified. Fortunately, by leveraging a long-term horizon and operating in a large, unconstrained universe, we’re able to identity a sufficient number of high-quality businesses that we can wait for the confluence of valuation, management, and capital structure, ultimately allowing us the full expression of our philosophy in our portfolios.

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[1] Security Analysis (1934)

IMPORTANT NOTES & DISCLOSURES

The information, analysis, and opinions presented herein are for discussion and educational purposes only. This presentation is not an offer to sell securities of any investment fund or a solicitation of offers  to buy any such securities. Nothing contained herein should be construed as investment advice nor should it be relied on in any manner as legal or tax advice, or as an offer to sell or a solicitation of an offer to buy investment advisory services. Securities of the funds managed by Reference Equity are not offered to investors. All investments involve risk and, unless otherwise stated, are not guaranteed.

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