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What constitutes a quality business?

quality

What constitutes a quality business?

With the demise of Silicon Valley Bank (SVB) and the effect on Credit Suisse – its share price has declined 90 per cent in five years to CHF1.70 – I thought it appropriate to return to basics and dig a bit deeper into what constitutes a “Quality” business, also known as a “Compounding Machine.”

  1. A sustainable competitively advantaged business model means an economic moat which is hard to replicate due to, for example, high switching costs, network effects, dominant brands, scale leadership, or unique niche. These businesses generally have pricing power or a cost structure advantage. Given capitalism conspires to compete away competitive advantage, a significant question is the durability of the economic moat.

  2. Structural growth opportunities give a high-quality company the ability to reinvest its free cashflow to become a “compounding machine”. Below, I give an example of two companies – one which produces free cashflow (at 25 per cent of Net Operating Profit After Tax), meaning there is residual cashflow left over for M&A activity, dividends or buybacks – and one where the cost of growth via capital investment exceeds earnings meaning negative free cashflow for the company (at negative 50 per cent of Net Operating Profit After Tax). It is this cost of growth calculation which analysts often under-estimate

  3. Trustworthy stewards of capital – self-explanatory in that investors should avoid companies where the leadership benefits insiders at the expense of other shareholders. Businesses run by leaders that are strategic in their approach, have a clear, long-term vision and a culture of excellence, humility and trust.

  4. Self-financed growth and robust balance sheets is an attribute which is often over-looked when markets are running, or when interest rates were approaching historic lows. It is free cashflow which determines a company’s ability to compound value over time. It is cashflow that supports a company’s balance sheet, funds capital investments, and provides a source of returns in the form of dividends or buy-backs. Robust cashflow businesses rely less on debt or equity capital raisings to fund growth.

Company 1

(US$m)

 

 

Company 2

(US$m)

 

 

Net Operating

Profit After Tax (NOPAT) – 15% p.a. growth

Capital Investment =

75% of NOPAT

Free Cash Flows =

25% of NOPAT

Net Operating

Profit After Tax (NOPAT)-

15% p.a. growth

Capital Investment =

150% of NOPAT

Free Cash Flows =

Negative 50% of NOPAT

100

 

 

100

 

 

115

86

29

115

173

-58

132

99

33

132

198

-66

152

114

38

152

228

-76

175

131

44

175

262

-87

201

151

50

201

302

-101

231

173

58

231

347

-116

266

200

67

266

399

-133

306

229

76

306

459

-153

352

264

88

352

528

-176

405

303

101

405

607

-202

4.05X = 15% CAG over 10 years

15% CAG

15% CAG Aggregate FCF is $584

4.05X = 15% CAG over 10 years

15% CAG

15% CAG Aggregate FCF is negative $1167

In summary, Company 1 spends 75 per cent of its annual Net Operating Profit After Tax (NOPAT) on Capital Investment leaving it with US$584 million of cash at the end of the ten-year period under review for M&A activity, dividends or buybacks.

Company 2 spends 150 per cent of its annual Net Operating Profit After Tax on Capital Investment leaving it with negative US$1,167 million of cash at the end of the ten-year period under review and will need to tap the debt and/or equity markets to continue as a going concern. I repeat, it is this cost of growth calculation which analysts often under-estimate. 

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Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

    • Hi Alexandros, NOPAT is Net Operating Profit After Tax. A lot of analysts “normalise” this number by adding back the Amortisation of Goodwill, a non-cash item. This usually comes about from past acquisitions where the Company in question pays a multiple of the acquired company’s assets back. this creates the goodwill. And the accounting standards often require this figure to be “written off” over many years. It becomes a negative figure in the NOPAT calculation and to recap is a “non-cash” item. Thank you.

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