Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 67

Quality over quantity: a lesson of value

There are, broadly speaking, two kinds of stock market investors in this world: those who believe they can beat the market and those who don’t. The latter group of investors tends to buy index-style funds that hold shares in nearly every company in proportion to their index weight to ensure delivery of the market return, net of fees, with little deviation.

But what about the former group of investors? One philosophy which has demonstrated sustainable outperformance of the market over long periods of time is that of ‘value investing’. Under this philosophy, the investor will hold shares in fewer companies which are of relatively higher quality and purchased at relatively lower valuations.

While many subscribe to these ideas, putting them into practice is not a trivial task. One area that many investors grapple with is articulating precisely what constitutes a ‘high quality’ business. One way to think about the quality of a business is to answer the following question: how easy would it be for a competitor to recreate the business? If the answer is ‘very easy’ – as would be the case for, say, a corner store, then the quality of the business is low. On the other hand, if the answer is ‘very difficult, time consuming or costly’ – as is the case for, say, Facebook, then the quality of the business is high.

When thinking about how to answer this question, one can think of three key sources of quality. A business can be qualitatively evaluated for these elements with a check-list type approach. The three sources of quality are: economies of scale, customer captivity and government protection, such as licenses or patents.

Economies of scale relate to the dynamic of bigger businesses exhibiting a cost advantage over smaller businesses. When fixed costs can be spread across a larger quantity of goods and services, average unit costs are lower. Furthermore, bigger businesses can exhibit stronger bargaining power over suppliers and drive more favourable terms than smaller businesses. We are seeing this dynamic all too clearly in the Australian supermarkets space.

Customer captivity relates to the ease with which customers can switch to a competitor. A business that has a large degree of customer captivity is often more successful in pushing through higher prices. There are various forms of customer captivity. These include integrated systems between the business and its customers, as is the case for Visa and Mastercard, as well as customer loyalty programs that effectively increase the cost for customers to switch.

Finally, when a business has privileged access to resources or a patent, this represents an advantage that cannot easily be recreated by competitors. For instance, one of the reasons why BHP is such a world-class business is because it has government-protected rights to mine the natural resources of Australia and other nations. Without these rights, the company’s quality would be severely impaired. Patents on new technology create a similar degree of quality to the extent they are protected by the government.

Value investors will aim to hold portfolios of shares in companies that exhibit many of the elements described above. As long as the investor does not overpay for these businesses initially, they can be reasonably assured of market outperformance over long periods of time. These principles of value investing are worth keeping in mind for both individual investors as well as those looking to evaluate the investment managers of externally-managed funds.

 

Andrew Macken is a Senior Analyst at The Montgomery Fund

 


 

Leave a Comment:


RELATED ARTICLES

What makes a company attractive?

Learn your knowns and unknowns

Value investing and valuing a business

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Shares

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

Exchange traded products

AFIC on its record discount, passive investing and pricey stocks

A triple headwind has seen Australia's biggest LIC swing to a 10% discount and scuppered its relative performance. Management was bullish in an interview with Firstlinks, but is the discount ever likely to close?

Superannuation

Hidden fees are a super problem

Most Australians don’t realise they are being charged up to six different types of fees on their superannuation. These fees can be opaque and hard to compare across different funds and investment options.

Shares

ASX large cap outlook for 2025

Economic growth in Australia looks to have bottomed, which means it makes sense to selectively add to cyclical exposures on the ASX in addition to key thematics like decarbonisation and technological change.

Property

Taking advantage of the property cycle

Understanding the property cycle can be a useful tool to make informed decisions and stay focused on long-term goals. This looks at where we are in the commercial property cycle and the potential opportunities for investors.

Investment strategies

Is this bedrock of financial theory a mirage?

The concept of an 'equity risk premium' has driven asset allocation decisions for decades. A revamped study suggests it was a relatively short-lived phenomenon rather than the mainstay many thought.

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.