JSE Power Hour – Quality Investing Keith McLachlan 31 May 2018

/keithmclachlan

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Agenda

What is “quality investing”?

Attributes of a quality company

Barrier(s) to Entry & Competitive Advantage(s)

Scalability

Incrementalism

Alignment of interest & governance

Many others

Financial metrics of quality

Quartile proof on the JSE

Four simple metrics of quality

Examples of quality on the JSE

Santova Logistics (SNV)

Master Drilling Group (MDI)

Adcock Ingram (AIP)

Summary

Questions

What we are going to talk about tonight…

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What is “Quality Investing”?

What is “Quality Investing”?

Cognitive bias created by looking at shares before looking at businesses.

Quality investing inverts this process:

Is it a good business?

If not, then move on.

If it is a good business, then consider how much you are paying (i.e. valuation)?

Why does quality investing matter?

In the long-term, your investment performance is only determined by the fortunes of the underlying business.

Logically, good businesses do better than bad businesses.

Warren Buffett: “Time is the friend of the wonderful company & the enemy of the mediocre one.”

Invest in good businesses, sleep better at night and be excited for their next set of results!

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What is it and why does it matter?

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Attributes of a Quality Company

Attributes of a Quality Company

Barrier(s) to Entry:

Stops new competition.

Takes only three forms:

Legal: Legal reasons that other players cannot enter an industry, from patents and licenses to regulation, compliance and Government protectionism. E.g. Banks, casinos, hospital & telecos.

Natural: Self-built barriers like brands, customer loyalty and switching costs. E.g. Food brands, retailers, medical aids, insurance companies and financial services.

Scale: Returns to scale and capital needs preventing new players entry the market. The weakest of all the barriers to entry. E.g. Manufacturing & construction companies.

Competitive Advantage(s):

Helps a business beat existing competition.

Takes only three forms:

Price: Can produce good or service cheaper than anyone else. E.g. Mines.

Quality: Can produce a better good or service than anyone else. E.g. High-end car companies.

Niche/differentiation: Offers something unique that a competitor cannot. E.g. Google or Apple.

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Barrier(s) to Entry & Competitive Advantage(s)

Attributes of a Quality Company (cont.)

“Scalability” is a business’s ability to grow its volumes at a faster rate than it grows its costs.

I.e. The ability of a business to get exponentially bigger.

This is a combination of a number of factors:

Size of potential addressable market,

Incremental marginal cost of further volumes, &

Ability of core business to efficiently handle volumes.

I.e. So-called “platform businesses”.

E.g. Facebook, as with most other social media businesses.

Other types of businesses that scale beautifully:

Asset management,

Telecos,

Software, &

Many, many others.

Note: Acquisition strategies are never scalable.

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Scalability

Attributes of a Quality Company (cont.)

Incrementalism means three unrelated things:

1. Selling lots of small things instead of one large thing:

Lowers risk of sale and lessens impact of a missed sale,

Often means a subtly better pricing power (e.g. look at “Chappie inflation”), &

Means steady improvement as “learning curve” plays out quicker.

2. Incrementally improving the business each period:

Are management continuously improving the business (& not just responding to crises)?

Sir Dave Brailsford, Head of British Cycling, drove the British cycling to Olympic gold by a process of continuous marginal gains where “…the team broke down everything they could think of that goes into competing on a bike, and then improved each element by 1%...”

3. “Shoot bullets, not cannons”:

Does management make incremental capital allocation decisions before risking the balance sheet?

A key element in risk-adjusted capital allocation.

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Incrementalism

Attributes of a Quality Company (cont.)

Skin in the game:

Management should own shares in the company they manage.

Alignment of interest like this is powerful.

Honesty & transparency:

Honest management is a prerequisite for investing as a minority shareholder.

Lack of transparency often a warning sign, as management either hiding something and/or not managing the business for the benefit of all shareholders.

Good corporate governance:

The above two are more important in my mind than the King Code.

I would rather have alignment of interest than overpaid, passive independent directors that add no value (e.g. consider how many independent directors sat on Steinhoff’s Board…?).

Still, good corporate governance remains very important.

Everything else pretty much flows from these “soft fundamentals”…

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Alignment of interest & governance

Attributes of a Quality Company (cont.)

Business satisfies “timeless” demands:

Offers more, easier &/or cheaper, &/or

Makes people happier, safer, wealthier &/or healthier.

Timeless wants = eternal demand.

E.g. Amazon offering more products for a lower price.

The Network Effect:

One of the benefits of scaling a business.

Some businesses eco-systems grow in value exponentially.

E.g. Stock markets, social media networks & 4PL supply chains.

Potentially many more unique attributes of quality companies, but they all share one thing in common:

They help to sustainably and profitably maintain and grow the business.

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Many others

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Financial Metrics of Quality

Financial Metrics of Quality

I have ordered the JSE into quartiles of best-to-worst over 10 year period based on “total return”.

I have pulled aggregate financial metrics for each quartile averaging as far back as practically possible.

Consistently, best performers have higher returns, wider margins, and lower debt.

Interestingly, growth in earnings only really mattered for the lowest quartile (which was well below the rest).

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Quartile proof on the JSE

Total Return (10yr average %) ROE (5yr average %) Gross Profit Margin (%) Net D:E (%) EPS Growth (5yr average %)*

Quartile 1 25.8 28.9 41.6 13.7 13.0

Quartile 2 16.2 19.2 33.0 20.2 15.2

Quartile 3 8.5 15.0 35.7 19.2 13.4

Quartile 4 - 7.3 1.7 24.6 201.9 6.7

- 1.0

4.0

9.0

14.0

19.0

24.0

29.0

34.0

39.0

Fin

anci

al M

etri

c

JSE Quartiles Ordered by 10 year Average Total Return

Sources: Bloomberg & AlphaWealth workings & assumptions; * Uses “median” earnings growth due to large outliers distorting averages.

Best

Worst

Financial Metrics of Quality

From prior slide’s proof, the financial indicators of quality are actually quite simple:

Return on Equity (ROE):

Profit divided by the equity needed to generate that profit.

The higher the better.

Debt/Equity (D:E):

How much debt you hold for every R1 of equity you have built.

The less the better.

Gross Profit (GP) Margin:

How much you can sell a good/service relative to direct input costs used to generate good/service.

The higher the better.

Growth in earnings:

Growth in bottom-line, directly attributable shareholder profits per share.

The higher the better, but only equally as important as the above metrics.

I.e. Not growth at all cost, but sustainable growth that matters.

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Four simple metrics of quality

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Examples of Quality on the JSE

Examples of Quality on the JSE

Business model: Non-asset based supply chain manager with a growing global network.

Barrier(s) to Entry & Competitive Advantage(s): Natural & scale barriers with price & niche IP/systems.

Scalability: As an asset-lite, software-based model, Santova’s business is very scalable.

Incrementalism: Hyper amounts of small transactions and continual improves in system, process and Group.

Network Effect: Trade route, client pairing & buy-rate compression all steadily improve with growing network.

Return on Equity (%): 17.1% for FY 18 (would have been higher if ZAR had not strengthened)

Net Debt:Equity (%): 46.5% (ignoring debtor financing, true debt much lower)

Gross Profit Margin (%): N/A due to billing model, Net profit margin is c.22%

Earnings Growth (%): +12.4% in FY 18 (would have been closer to c.+15% to +20% if ZAR had not strengthened)

Hence, I view Santova as a high quality stock.

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Santova Logistics Ltd (SNV)

Examples of Quality on the JSE

Business model: Global raisebore driller with a mobile, largely automated fleet.

Barrier(s) to Entry & Competitive Advantage(s): Natural & scale barriers with quality & IP niche advantages.

Scalability: Scalability into parallel industries and other drilling services + spare capacity.

Incrementalism: Continuously improving their fleet with in-house IP, inventing new drills/services, & drilling service is a “small-but-vital” cost in underground mining capex.

Alignment of interest: Management owns majority of the company.

Return on Equity (%): 10.8% (this ratio and below all in $’s) for FY 17

Net Debt:Equity (%): 2.4% at end of FY 17

Gross Profit Margin (%): 36.8% during FY 17

Earnings Growth (%): -3% for FY 17, but very robust long-term prospects

Hence, I view Master Drilling Group as a high quality stock.

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Master Drilling Group Ltd (MDI)

Examples of Quality on the JSE

Business model: Healthcare product business with generics, OTC and complementary focus in consumer space

Barrier(s) to Entry & Competitive Advantage(s): Legal barriers to entry & niche/brand competitive advantages.

Scalability: Dossier pipeline at the SAHPRA (new-MCC) + spare capacity at factories can be filled at little cost.

Incrementalism: Selling large volumes of IP-rich, inelastic healthcare products to a broad consumer market that is buying both the product and its brand name.

Return on Equity (%): 17.7% for H1:18

Net Debt:Equity (%): Ungeared at end of H1:18

Gross Profit Margin (%): 37.8% during H1:18

Earnings Growth (%): HEPS grew by +33% during H1:18

Hence, I view Adcock Ingram Holdings as a quality stock.

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Adcock Ingram Holdings Ltd (AIP)

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Summary & Questions

Summary

Quality investing inverts the process of normal stock selection:

Firstly, is it a good business?

If not, then move on.

Finally, if it is a good business, then consider how much you are paying (i.e. valuation)?

There are many attributes of a “good business” or a “quality company”:

Barrier(s) to Entry & Competitive Advantage(s),

Scalability,

Incrementalism, &

Alignment of interest & governance, amongst others.

In the long-term, these can all be distilled down into four financial metrics:

Return on Equity,

Net Debt:Equity,

Gross Profit Margin, &

Earnings growth.

Finally, be patient and let compounding happen.

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Find great businesses at good prices and invest in them

“Time is the friend of the wonderful company & the enemy of the mediocre one.” — Warren Buffett

Questions

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31 May 2018

Quality Investing – Keith McLachlan

Disclaimer

None of the information or opinions expressed in this article constitute an offer to sell or the solicitation of an offer to sell investment products. This material is for information purposes only. The opinions expressed in this article do not constitute investment, tax or other advice and you should consult your professional advisor before you make any decision. The value of currencies, securities or investments and the price of shares which are mentioned in this article may fall as well as rise. Investors may not receive the original amount invested in return. Investors should also be aware that past performance is not necessarily a guide to future performance. All expressions of opinions are subject to change without notice. Alpha Wealth is registered with the Financial Services Board as a financial services provider (License No. FSP13808).

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