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Shortly after agreeing the purchase of my first home, I phoned my parents, looking for reassurance. I was putting everything I had ever saved into a modest deposit and taking on more debt than I had ever imagined to buy a small flat. There were cheaper, larger and flashier flats on the market, but this one had the right location, the right proportions and, for want of a better word, the right quality. “Don’t worry” my father said, as have others before him, “quality is remembered long after price is forgotten”.
He was right of course (he often is). I loved that flat and when I came to sell it, despite a very shaky housing market, someone else was prepared to pay a premium for the same quality I first fell in love with. The message to me was clear and the lesson well-learned: Quality delivers over the long term.
The same can be said of equity investing, albeit pinpointing exactly what quality is and how we should measure it is harder. Unlike some, we do not believe the acid test is the historic return on equity ratio, the stability of historic margins or even the strength of a balance sheet. It is the interaction of numerous factors that create the conditions for a company to grow and thrive over many years. It is in a company’s ability to take advantage of the opportunities ahead of it, to be resilient to the inevitable challenges it will face, and to adapt and evolve as the world changes.
These are the attributes that enable companies to thrive, not just from quarter to quarter, or even year to year, but from cycle to cycle and decade to decade. Investors who are prepared to seek out such companies, and have the patience to stay with them for the journey, may be rewarded with extraordinary long-term returns.
In the investment world, quality seems to be like beauty: very much in the eye of the beholder. Most investment managers claim to invest
in “quality” businesses, but the definition of that quality can be frustratingly elusive. Index providers offer greater precision but whereas the MSCI Quality factor index uses return on equity, debt to equity and earnings variability as its three fundamental variables, others offering similar indices opt for slightly different quantitative inputs.
Two elements that do unite most definitions of investment quality across those that share their approaches are a focus on quantitative metrics and stability. Such elements clearly have their merits. We have long highlighted the superior return on equity and lower debt levels that characterise the International Alpha portfolio in aggregate. We have also praised the extraordinary consistency of delivery by companies such as TSMC, one of our longest standing holdings, and a company that unquestionably fits our definition of quality.
Financial analysis and an emphasis on stability are not enough, however, to fully capture what we consider the essence of a “quality” growth investment. Not only do quantitative metrics invariably draw the eye towards the past, but an obsession
with stability can be dangerous too. There is great value in a business that can weather economic storms over many decades, but stability for stability’s sake is a dangerous ambition. Yesterday’s stable profit growth may betray a lack of investment that dooms a business to disruption and decline tomorrow.
The phrase “quality will remain long after the price is forgotten” is attributed to Sir Henry Royce, founder of the Rolls Royce motor company. Were he still alive he might be pleased to know the enduring quality of his vehicles is still appreciated nearly a century after his death. As a case in point, in 2012 a Rolls Royce Silver Ghost bought for £1,000 in 1912 was sold in auction for £4.7m – nearly 50x the return general inflation would have delivered over the same period.
Ultimately, for long-term investors it is crucial to look beyond quantitative metrics. While characteristic of many great companies, on their own they prove poor predictors of future investment returns. Reported financial metrics tell us how things were, rather than how they are going to be. They may help in identifying past winners, but not necessarily the long-term winners of the future and certainly not the emergent winners that defy traditional definitions of “quality”.
Quality enterprises of the internet age, for example, are particularly poorly served by traditional quantitative definitions and accounting methodologies. The great growth businesses of yesteryear may well have required physical assets to support their upward trajectory. Assets such as factories would have been capitalised and expensed gradually to the profit and loss account, stabilising earnings and enabling profits to be reported far earlier in a company’s development. The equivalent investments of the internet age are far more likely to be intangible.
Take advertising to establish brand identity and providing services at a loss. The future value creation of entrenching online platforms in this way can be vast, yet the short-term financial outputs look ugly to the quants, as Mercadolibre and Spotify testify. These two holdings contribute more to the earnings growth volatility of the International Alpha portfolio than any other. More, in fact, than the next six holdings combined. Would the “quality” of the International Alpha portfolio be improved by these companies reining in spending and managing to a margin target? Certainly not.
A quality growth investment is defined far more by its inputs than it is by the financial outputs that anyone with a Bloomberg terminal can screen for. Identifying inputs is where in-depth fundamental research adds greatest value. Quality growth investments have the opportunity to grow over many years but they also need the ability to withstand pressure from competitors attracted by the same opportunity and to keep going through inevitable setbacks. Finally, they need the execution skills to capitalise on their circumstances, to create new opportunities and to adapt to emergent threats as the world changes around them.
While the growth aspect of an investment case invariably focuses on opportunity, the elements that define quality depend more heavily on ability and execution. We ask: What is a company’s competitive advantage and why will it endure? How resilient is its operating and financial model to unexpected disruptions, whether internal or external? Is there something special about the management or ownership of the company that makes it more likely success will be sustained? Only by addressing these questions and gaining insight on these qualitative inputs can we hope to understand whether the quantitative outputs of a business are likely to endure or improve over our expected holding period.
Competitive advantage is the defining factor between a company that grows and creates value and a company that merely grows.
History is littered with great growth opportunities that made very few wealthy. Glittering prizes lost among a stampede of undifferentiated competition. Competitive advantage enables superior returns when the tide is rising and, sometimes just as important, can be the key determining factor in surviving hard times to emerge stronger on the other side. These are the companies that we look to own.
Between 1997 and 2012 the semiconductor memory industry grew rapidly, yet according to McKinsey it generated cumulative economic losses of $9.5 billion on cumulative revenues in excess of $700 billion. Only when the industry consolidated around a handful of winners with clear scale and technology advantages, such as Samsung Electronics, did the balance shift. Between 2013 and 2017 cumulative economic profits were $58 billion, despite that period including two years of industry recession.
Competitive advantage comes in enough forms to justify an entire book, however a few examples may be useful to demonstrate the point. Novozymes has spent decades investing in research, development and manufacturing know-how. The outcome is dominance of its technology niche (industrial enzyme manufacturing), a technology advantage that is likely to endure for decades, and excellent financial returns. Ryanair makes no such claims on technology. It flies the same people on the same airplanes into the same airports as its rivals, yet with a business model whose entire focus has always been on removing all unnecessary cost. The result is a cost of operation that peers still find impossible to replicate and a business that in just 30 years has risen from nowhere to become Europe’s largest airline. Finally, certain markets offer scale advantages that mean they have a natural tendency towards monopoly. Once leadership has been attained it can be incredibly hard to displace. This is true for many online business models, but is equally true of much more ancient enterprises, such as stock exchanges like Deutsche Boerse and Hong Kong Exchanges & Clearing. They trace their roots back to the 16th and 19th centuries respectively and, while not held for quite so long in International Alpha, it is no coincidence that they remain among our portfolio’s longest standing holdings.
If recent history has taught us anything, it is surely that you never quite know what is coming around the corner. We claim no expertise in predicting cycles or pandemics, only a high degree of confidence that if we hope to hold an investment for five to ten years or more then disruption is inevitable at some point. Whether macroeconomic, microeconomic, regulatory or other, the ability to cope with said disruptions, and even take advantage of them, is for us a hallmark of quality.
Balance sheet strength is an obvious factor in business resilience and is commonly used in quantitative definitions of quality. All else being equal, high levels of gearing increase the chance of insolvency and reduce a company’s flexibility to keep investing when times are tough. Though financial theory long extolled the doctrine that debt in a capital structure should lead to superior returns for equity holders, there is even evidence that the opposite may be true. The consistent preference within the International Alpha portfolio for companies with lower levels of debt certainly reflects an appreciation of such attributes.
The balance sheet is only one part of the picture, however. The operating and financial model can be just as significant, though harder to assess. A retailer and an industrial engineer might not be the first two businesses that spring to mind when thinking of resilience, but they illustrate why balance sheets might be just a part of the story.
The uniquely flexible and reactive supply chain model developed by Inditex, the world’s largest fashion retailer, has enabled it to outgrow and out-earn its peers while expertly navigating the whims of mass-market fashion, the structural upheaval of high street retail and the recent global shutdown. Another example is Kone, one of the world’s largest elevator manufacturers, the sales mix and manufacturing model are key. While new equipment sales are cyclical, the aftermarket servicing of installed equipment is incredibly constant and a capital light manufacturing model ensures great flexibility in its cost base.
60% of the portfolio invested in companies with supportive long-term ownership structures, a further 10% aligned by management tenure
The attributes described above go some way to determining the ability of a company to deliver great outcomes, but they miss out on arguably the most important input. We have great sympathy with Warren Buffett’s famous advice to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will. That said, we’d rather avoid such a scenario if we can. We believe how a company is run, who runs it, who owns it and how alignment is created between long-term shareholders and those in control are vital ingredients to long-term success and are therefore intrinsically linked to any assessment of quality.
We believe “quality” stewardship is defined by the strategic vision and bravery to stay one step ahead of the game, the prioritisation of long-term value creation over short-term profit maximisation, the balanced consideration of all stakeholders in decision making and the delivery of sustained operational excellence. These factors don’t only contribute to the existence of superior financial returns but are intrinsic to their sustainability. They can, however, be fiendishly difficult to identify from the outside.
In the case of longstanding management teams, such as Peter Wennink and Martin van den Brink at ASML, excellence may be evidenced by the outcomes delivered over multiple decades. Not every company is blessed with such leadership, however. With our holding period comfortably exceeding the average tenure of a CEO, we are often obliged to look more deeply for reassurance that the companies we invest in will be run in the best interests of long-term shareholders.
The issue of alignment of interests is one of the great challenges of modern-day capitalism. Strong governance structures, well-devised remuneration schemes and large management shareholdings can help, but one of the best ways to overcome this challenge is simply to invest alongside the founders of a business or their descendants.
We believe the presence of visionary founders, such as Marcos Galperin at Mercadolibre, Shigenobu Nagamori at Nidec, Pony Ma at Tencent and Piet van der Slikke at IMCD, has been instrumental in the long-term success of these businesses. When founders move on, substantial equity ownership by their descendants can still have significant beneficial effects, as can meaningful ownership by similarly long-term institutions such as holding companies and foundations. These ownership structures provide professional managers at Kuehne + Nagel and Chr Hansen with the stability and support to think about their businesses in terms of decades rather than quarters and invest accordingly. In a world where the average shareholder sticks around for just one year that stability and support is a considerable luxury.
The attractions of shareholder structures such as these explain why companies that enjoy them form nearly 60 per cent of the International Alpha portfolio. Companies like ASML, without such ownership support but run by executives with over a decade of leadership at the company to judge them by, form a further ten per cent.
Our goal as quality growth investment managers is to allocate capital and let the power of compounding take over. Traditional financial theory tells us we should expect a reversion to the mean for businesses that enjoy supernormal margins or returns, yet empirical evidence suggests this is not the case for all companies. How else, after all, could fewer than 4 per cent of all stocks account for all the value created by the US equity market between 1926 and 2015 and fewer than 1 per cent of all stocks account for all the value created in the international equity universe between 1990 and 2018? Much of this relates to the compounding effect of growth delivered over many years and the ability to do precisely that invariably comes down to the softer factors that we identify as the true definition of quality.
Where companies can combine a good number of the quality factors we have described, the outcomes can be extraordinary. For example, one portfolio holding, Sweden's leading industrial engineering business, is still thriving 147 years after foundation and 18 years since it was bought at the inception of our strategy. The quantitative outputs are hugely impressive but this is the output of, among many other things, a supportive shareholder structure, a capital light and cash generative business model, sustained investment in industry-leading innovation and a willingness to make bold capital allocation decisions. The same could be said of many of the names mentioned above.
When quality and growth combine
Since 2002, Sweden’s leading industrial engineering business has experienced declines in market capitalisation of over 2 per cent on nine separate occasions, the most extreme of which being a 71 per cent decline in 2008. Despite these bouts of volatility, over the same period the company’s market capitalisation has increased in value by approximately 1,400 per cent.
Source: Baillie Gifford, MSCI.
It is no coincidence that the median holding period for the International Alpha investments named in this document is 10 years. Our focus on quality is intrinsically linked to our desire to entrust client capital to companies that can be held long enough to allow the wonder of compound growth to take over. The danger is in thinking that quantitative outputs are the sole arbiter of quality and not appreciating these outputs are only possible when the right inputs come together. Our role as active equity managers is to invest the time and effort to understand those inputs, to look beyond the easily identifiable historical outputs and in doing so create value for our clients over the long term.
The views expressed in this article are those of Tom Walsh and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in November 2020 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
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The images used in this article are for illustrative purposes only.
Annual Past Performance to 30 September Each Year
International Alpha Composite (%)
MSCI AC World ex US
Source: Baillie Gifford & Co. GBP. Net of fees. *MSCI AC World ex US
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Tom is a portfolio manager for International Alpha clients and a member of the International Alpha Portfolio Construction Group (PCG). He joined Baillie Gifford in 2009, working on the UK, European and Global Opportunities Teams, as well as spending four years as a member of the International All Cap PCG. Before joining Baillie Gifford, Tom worked at Fidelity International, Merrill Lynch and Deloitte & Touche. He graduated LLB (Hons) in Law & Economics from the University of Edinburgh in 1999 and is both CFA and ACA qualified.