Key qualitative attributes high quality companies must have

In last week's post, titled 'Key quantitative metrics to identify high quality companies', we delved deep into which financial metrics best serve as a proxy to discover high-quality companies. We also covered some companies as examples to better understand what different values on these metrics mean. However, this numerical part is only one step in the process of studying a company. Even more important than analyzing the financial metrics is understanding what a company does and what its competitive advantages are. This is a very subjective process, and that's why investing is usually considered more an art than a science. In today's post, we will try to outline the minimal structure that this subjective process should cover.

Before investing our money in any company, it's essential to have a clear understanding of its business. Answering the following questions can aid in this process:

• What products or services does the company sell? What are its different revenue streams? That is, do you understand how exactly the company earns money?
• How stable is the demand for the company's products?
• Is the company highly dependent on external factors?
• In which countries does the company operate?
• Does the company demonstrate faster growth compared to its competitors?
• How easily can the company's market be disrupted?

Before buying a stock, ask yourself if you would still buy it knowing that the stock market would be closed for the next 10 years and you couldn't sell it.

Warren Buffet.

Once these aspects are clarified, it's important to assess whether the company possesses competitive advantages that will enhance its future prospects. These advantages, often referred to as "MOATs" in the investment world, function similarly to the protective barriers surrounding ancient castles, shielding companies from competitive threats. Two key figures in analyzing MOATs are Pat Dorsey, a current fund manager who authored 'The Little Book That Builds Wealth' in 2008, which delves into identifying and detecting company moats, and Michael E. Porter, a Harvard University professor renowned for his Porter's Five Forces Framework, a method for analyzing a business's competitive operating environment. We will now explore the contributions of both individuals.

Porter's Five Forces Framework

1. Threat of new entrants: Renowned businessman Peter Thiel succinctly explains, 'If you have direct competitors, price competition will drive your profit margins to zero.' Barriers to entry mitigate the threat of new entrants, offering established companies advantages over newcomers. Since all MOATs are considered examples of entry barriers, to avoid overlap, we will cover them later.
2. Threat of substitutes: Substitute products utilize different technologies to fulfill the same economic need. For instance, a new vegan burger company could impact a company whose primary revenue stems from selling traditional meat burgers.
3. Bargaining power of customers: Buyer power is high when customers have numerous alternatives and low when choices are limited.
4. Bargaining power of suppliers: Similar to the previous point but from the perspective of the supply chain.
5. Competitive rivalry.

Pat Dorsey on MOATs

Many investors perceive great products, strong market share, excellent execution, and effective management as competitive advantages. However, Pat Dorsey considers these factors the most common 'mistaken moats.' These traps can lead investors to believe a company possesses a moat when it likely doesn't. According to him, while management matters, moats matter far more.

What are then real moats according to Pat?

1. Intangible assets such as brands, patents, or regulatory licenses allowing companies to offer products or services unmatched by competitors.
• A brand creates an economic moat if it either increases consumer willingness to pay or enhances customer captivity. An example we all know is Apple.
• Patents offer a sustainable competitive advantage when coupled with a demonstrated track record of innovation and protection against legal challenges.
• Examples include companies like Moody's or waste haulers, which rely on permissions and approvals for operations.
2. Products or services that a company sells and that may be hard for customers to give up, which creates customer switching costs and give the firm pricing power.
• Banks are examples of switching costs industries. People don't change banks because of all the paperwork needed etc. Another type of business that benefits from this MOAT is cloud providers like AWS or Microsoft Azure. Switching providers can be a significant challenge for companies, requiring them to migrate all their data, train employees on new software, and more.
3. Network effect.
• The value of the company's product or service increases with the number of users. The network effect is much more common among businesses based on information or knowledge transfer than among businesses based on physical capital. Social networks exemplify this principle perfectly, as the more friends you have on these platforms, the richer your experience becomes, benefiting both yourself and the business owner.
4. Cost advantages stemming from process, location, scale or access to a unique asset, which allow companies to offer goods or services at a lower cost than competitors.
• Companies that benefit from this MOAT include cement plants. The high unitary cost of transporting cement often leads to local monopolies for cement plants due to the natural barriers to importation.

Closing

Before finalizing the post, we'd like to share a couple of intriguing thoughts. Firstly, it's essential to remind that technological change can destroy competitive advantage. This is though a bigger worry for companies that are enabled by technology than it is for companies that sell technology, because the effects can be more unexpected.

Secondly, it's worth noting that creating a competitive advantage varies across industries. Moats, as protective barriers, are absolute rather than relative. As an example, the fourth -best company in a structurally attractive industry may very well have a wider moat than the best company in a brutally competitive industry.

We hope you've found this post insightful. Remember, the overarching goal of qualitative analysis is to gauge a company's potential future value. By considering these broader perspectives alongside numerical metrics, investors can mitigate risks. Furthermore, when we factor in purchasing at a fair price, as we'll explore in the next post, we can potentially achieve excellent long-term returns.