Most investors (including myself) want to own “high-quality” companies, but our portfolios do not always match up to this standard. In this post, I focus on four qualities found in successful companies. These qualities form a solid basis for assessing new companies an investor may want to buy or for reviewing existing stock holdings. A robust investment process is essential for making consistently good decisions.
Wide Economic Moat
Most people are familiar with the moats that surrounded medieval castles to protect inhabitants against intruders. A deep, wide moat filled with water provided more protection than a shallow, narrow, dry moat. Similarly, an economic moat describes the sustainable competitive advantage that a company has built up to protect its business against competitors. Conservative investors want to own companies with wide economic moats.
The term “economic moat” was popularized by Warren Buffett. He claimed that “the most important thing in evaluating businesses is figuring out how big the moat is around the business.” Who are we to argue?
Canada has a relatively small population of 38 million and an area of nearly 10 million km2. Key Canadian industries that require large infrastructure investments are typically controlled by a few companies; these markets are called oligopolies. Oligopolies are generally advantageous for investors because of their inherent stability, but may be less so for consumers.
Examples of Canadian oligopolies include our banks (RBC Bank, TD Bank, Bank of Nova Scotia, BMO Financial Group, CIBC and National Bank), railways (Canadian National Railway, CP Rail), telecommunication providers (Bell Canada, Rogers Communications and Telus), pipelines (Enbridge and TC Energy) and utilities (Fortis, Emera and Canadian Utilities). The infrastructure these companies possess is a formidable barrier to new competitors.
Fortunately, Canadians may purchase shares of these companies and benefit from their growth. These investments are perfect for conservative, long-term investors due to their stability and ability to compound wealth over time.
Of course, infrastructure is not the only type of economic moat. Consumer companies invest money to develop superior products and build brand awareness, which often leads to consumer loyalty. Pharmaceutical companies secure patents for their drug inventions, which protects their inventions for a period of time. Software companies develop products that build large installed user bases or performs critical services that would lead to high client switching costs. Manufacturing companies scale up their operations to become the low-cost producer of a product.
In summary, the first quality investors seek in a company is a competitive advantage that differentiates the company from the competition. The competitive advantage needs to be persistent to preserve the companies market share and pricing power.
Sustainable Growth
The second quality investors look for in companies is a sustainable growth model. More specifically, they seek companies that grow their revenue, earnings and dividends on a consistent basis. Let’s look at each metric individually.
Revenue growth is a critical element to the long-term survival of a company. A successful company should be expected to grow its revenue above nominal GDP growth. If it has not able to meet this standard over a reasonable time period, say a decade, then competitors are taking away the company’s business or the market for the company’s products or services is shrinking. Enough said!
Conservative investors like to see earnings growth in line with revenue growth. They want to be confident that a company isn’t compromising their profit margin to increase revenues. Pure growth investors, on the other hand, are willing to delay earnings growth (and often even earnings) in the short term in expectation of large earnings in the future. Solid earnings growth in line with revenue growth provides a strong indication that the company’s growth is sustainable.
Dividend-paying companies send an important signal when they increase their dividends paid to shareholders. Strong dividend growth generally shows that management is shareholder-friendly and confident in the future of their business. Occasionally, the company’s financial statements do not seem to support the dividend increase – this is a clear warning sign for the investor to dig deeper and satisfy themselves that senior management knows what they are doing.
As an investor, I expect the companies I own to make regular dividend payments. This allows me to continually re-invest in my stocks that I believe are undervalued. Of course, this goes completely against the “efficient market hypothesis” that states that the market knows everything about the stock at any given time.
I am a firm believer that “fear” leads some investors to sell high-quality stocks when they trade well below their intrinsic value, providing excellent buying opportunities for value-oriented investors. Likewise, “greed” makes some investors overly-excited about the prospects of a stock when it is already priced to perfection, which provides an opportunity for a conservative investor to rebalance their portfolio at an opportune time.
Some investment managers make convincing arguments that dividends are irrelevant and that only total return matters. This statement is a bit misleading because it does not address investor objectives, risk management or behavioral aspects of investing. These same managers will sometimes begrudgingly acknowledge that dividend growth companies outperform the market in the long term1, 2, but they attribute this outperformance to factors such as value, profitability and quality.
Many investors don’t appreciate that dividends impose discipline on senior management to only fund their most profitable projects. Likewise, high-quality companies with growing dividends attract high-quality investors that support the stock price and contribute to lower stock price volatility. Dividend growth investors are attracted to companies that maintain a fairly constant dividend payout ratio so that the dividend yield provides an indication of whether the company’s stock is cheap or expensive. Smart investors take advantage of price volatility in these high-quality companies to add to positions when the dividend yield is high and the stock trades at a discount to its intrinsic value.
Management Excellence
The third quality is management excellence. This is the most subjective of the four qualities, but one that can be analyzed by careful observation over time. I will provide my thoughts on what I look for in company management.
Management provides both vision and direction for a company. Their vision tells you where they are taking the company in the long term, while their direction tells you the shorter term moves they are making on the path to achieving their vision. Shorter term actions should be consistent with their vision and focused on creating long-term shareholder value.
One of the key functions of management is to sustain the competitive advantages of a company. Companies always face challenges that potentially undermine their competitive advantage. It is possible to learn a lot about management by observing how they handle these challenges.
Management needs to achieve a balance between stretch goals that expand their competitive advantage while managing risk. I look for management that displays an entrepreneurial flair, while not risking their core business. For example, I like the move that Telus, a Canadian telecommunications company, made to spin off their digital consulting business (Telus International).
Telus is working on other entrepreneurial pursuits such as Telus Health, which is developing solutions to address inefficiencies in Canadian health care delivery. Telus Agriculture and Consumer Goods is developing solutions to address inefficiencies in the way consumer food and goods are produced, distributed and consumed. These new businesses build on Telus’ expertise and should drive demand for their core telecommunications and data services business. Telus is a core holding in my portfolio.
A strong management team will prudently manage their financial affairs to maintain a strong balance sheet. They will generally not make a move that puts the company’s financial health in jeopardy. Stay away from companies that have a history of increasing debt levels and diluting shareholders without delivering appropriate revenue, earnings and dividend growth.
A strong management team is focused on consistent execution of their short term business goals. Companies that do this successfully have fewer quarterly earnings misses and seldom report a serious earnings miss. When they miss their goals, it is important that management doesn’t make excuses. Exemplary management admits when they make a mistake and tell investors how they plan to address the situation.
Lastly, look for management that is passionate about their business and loves what they do. One example that comes to mind is Alain Bouchard, the Co-Founder and current Chair of the Board of Alimentation Couche-Tard. He recently did a rare interview with CBC/Radio-Canada in French that clearly shows his vision, dedication to his company and consummate attention to detail. Mr. Bouchard has grown Alimentation Couche-Tard (ATD-T) from a single store in 1980 to a public company with $60 billion in market capitalization today. I am proud to say that this company is a core holding of mine.
Exemplary Free Cash Flow Utilization
A successful business needs to generate free cash flow to fund their growth. Free cash flow is calculated by subtracting capital expenditures from operating cash flow. The free cash flow yield is calculated by dividing the free cash flow by the market capitalization. It measures the percentage of market capitalization available as cash to be allocated by management. A company in a particular industry that generates a higher free cash flow yield than its competitors has more flexibility to grow their business.
Successful investors are focused on understanding how much free cash flow a company generates, as well as reviewing how management allocates the free cash to generate long-term shareholder value. Management may use the free cash flow to make new capital expenditures, acquire another company, reduce debt, buy back stock, increase their dividend or build cash reserves. Strong management makes effective use of free cash flow while poor management squanders it by making poor decisions. Unfortunately, there are many examples of poor capital allocation decisions that subsequently lead to shareholder losses. I will share a few examples of poor capital allocation below. I will collect a few examples of excellent capital allocation decisions for a future post.
My first example of questionable capital allocation is Air Canada, a highly cyclical company in the airline business. Air Canada bought back over $800 million in stock between 2015 and the start of the pandemic. The stock price rose from $10 to $50 during this time period. This boosted the stock price, which allowed the CEO to pocket $52.7 million in profit from stock options issued in 2013. The time for the company to be buying back stock was from 2009 to 2013, when the stock price was trading below $5. Cyclical companies should be building cash reserves when times are good. Do you think Air Canada management was more focused on generating long-term shareholder value or enriching themselves?
While we are on the topic of share buy backs, investors should also question why a high-quality company like Apple is buying back shares when their share price is expensive. Back in September 2012, Apple had $82.6B in “trapped cash” from profits earned in foreign countries. The cash reserves were dragging down the company performance. Since then, Apple has spent $554B in share buybacks, reducing share count by almost one-third. Initially, the share buy backs made sense because the company was trading at a P/E ratio of 10. However, investors should question why Apple insiders have sold $810 million of stock (and notably no purchases) in the past four years, according to a Seeking Alpha article, while Apple spent $90B on share buybacks in 2022. Does this seem a little fishy to you?
There are numerous examples of company acquisitions that destroy shareholder value. I will use AT&T as an example to illustrate my point. AT&T purchased satellite operator DirecTV for $67B (including debt) in 2015 and a media company, Time Warner, for $85.4B in 2018. The two deals saddled AT&T with an enormous debt load.
A few years later, new AT&T management had to sell DirecTV to TPG Capital for $16B in 2021 and merged WarnerMedia (the rebranded name of Time Warner) with Discovery in 2022. It is difficult to assess how much shareholder value was destroyed by former AT&T management in these transactions, but shareholders have experienced a significant drop in both share price and dividend payments since 2015. The misguided acquisition strategy undoubtedly also distracted management from focusing on their core telecommunications business during this time period.
Closing Remarks
As a conservative investor, I seek to own high-quality companies that have four important qualities: a wide economic moat; a sustainable business model to grow their revenue, earnings and dividends; excellent management; and effective utilization of free cash flow generated by the business.
Based on my observations over the past 40 years, I have a strong preference for companies that return a portion of their free cash flow to shareholders as dividends. I am willing to accept a dividend yield below 2% when a company has a very strong business model and superb management. The sweet spot is often companies with a dividend yield between 2% and 4%, combined with fairly strong dividend growth. I also own a number of slower growing companies, primarily operating in oligopolistic markets, with dividend yields above 4%.
I am surprised that more investors do not appreciate the wealth compounding provided by dividend growth companies. Yes, wealth compounding may also occur in companies that don’t pay dividends, but the investor is placing a lot of trust in company management not to destroy the wealth. Many CEO’s are probably happy to operate with the constraint of having to pay a growing dividend to their shareholders. Lastly, regular dividend payments allow an investor to re-balance their portfolio on a regular basis during the wealth accumulation stage and to spend the dividends during retirement without ever generating a capital gain by selling shares.
This article has clarified my thoughts on four key qualities I seek in high-quality companies. I would love to hear your thoughts in the comment section below.
References
- Robert D. Arnott and Clifford S. Asness (2003), “Surprise! Higher Dividends = Higher Earnings Growth,” Financial Analysts Journal, 59:1, 70-83, DOI:10.2469/faj.v59.n1.2504
- Ping Zhou and William Ruland (2006), “Dividend Payout and Future Earnings Growth,” Financial Analysts Journal, 62:3, 58-69, DOI: 10.2469/faj.v62.n3.4