Urbem's 'Quality Strategy' Series: The Qualitative Traits

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“People with very high IQs and who are good at math naturally look for a system where they can just look at the math and know what security to buy. It’s not that easy. You really have to understand the company in its competitive position and the reason why its competitive position is what it is and that is often not disclosed by the math.” – Charlie Munger (Trades, Portfolio), vice chairman of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B)

The increasing applications of computing and data have been transforming the investment world. The so-called quant-investing (or algo-investing) has emerged based on sophisticated mathematical models to help investors capture alpha opportunities.

At Urbem, we do appreciate and leverage the technological advancement to efficiently screen for possible “wonderful businesses.” Nonetheless, qualitative factors are arquably better at telling us about the prospects of a business than the numbers achieved to date. We will discuss several unquantifiable traits that we look for as long-term investors.

Moat

In a dog-eat-dog, capitalist world, nothing is more important for shareholders than protection from competition. In the case of a business already earning a consistently superior return on capital in the past, the economic moat (i.e., the durable competitive advantage) decreases its chance of deteriorating profitability or capital efficiency. In our view, the moat is hard to find and takes time to build in the business world, but highly rewarding to long-term investors. Companies typically derive their moats through intangible assets, such as brand (e.g., Hermes (XPAR:RMS)), network effect (e.g., Facebook (NASDAQ:FB)), patent (e.g., Novo Nordisk (NYSE:NVO)), distribution network (e.g., Mastercard (NYSE:MA)) and scale (e.g., Domino’s Pizza (NYSE:DPZ)).

Management

“You can’t make a good deal with a bad person.” – Warren Buffett (Trades, Portfolio), CEO and chairman of Berkshire Hathaway

We find that management is an essential but often underrated factor in the investment world. A good management team needs to be not only able but also trustworthy from a shareholder’s perspective. At Urbem, we particularly favor managers that are return on invested capitl-oriented (rather than purely growth-oriented), skillful and shareholder-friendly when allocating capital (think about share repurchases), honest when communicating with investors (e.g., Credit Acceptance (CACC)), is long-term focused (e.g., Graco (GGG)), frugal (e.g., Bob Kierlin and Fastenal (FAST)) and have a sizable stake in the business themselves.

Competitive landscape

We are interested in opportunities in a highly concentrated industry. A typical example is the tobacco industry. Thanks to increasing regulation and the resulting high barrier to entry, this high-margin market is dominated by only a couple of significant players, such as Philip Morris (NYSE:PM), British American Tobacco (LSE:BATS). Alternatively, it is widely seen that market niches are an excellent way to avoid intense competition (think about Tractor Supply (TSCO) dominating the rural-life retail space). Lastly, we also favor the apparent market leader in a highly fragmented industry, which presents consolidation opportunities – for example, Chemed (CHE) in the hospice industry.

Stability (or even something boring)

“The greatest companies in lousy industries share certain characteristics. They are low-cost operators and penny-pinchers in the executive suite. They avoid going into debt. They reject the corporate caste system… Their workers are well paid and have a stake in the companies’ future. They find niches, part of the market that bigger companies have overlooked. They grow fast – faster than many companies in fashionable fast-growth industries.” – Peter Lynch, Beating the Street

Rather than guessing what will perform well eventually, investors should bet on things that rarely change. The management team can make decisions easily and build business strategies to be executed efficiently around things that are stable over time. Furthermore, businesses would be under fewer attacks in a slowly-moving or no-change industry, which makes competitive advantages more enduring.

Take a look at Rollins (ROL), which specializes in pest and termite control. This is a business that could bore almost anyone, except for its long-term shareholders who have observed consecutive year-over-year increases in revenue, gross profit and operating income for more than two decades now. We highly doubt that any technology company can achieve such a record.

As Peter Thiel, co-Founder of Paypal (PYPL), pointed out, when you hear a lot of buzzwords about an investment opportunity, you should think fraud and run away as fast as you can. Maybe in today’s world, these trendy buzzwords could be “AI,” “5G,” “Machine Learning” or “China market.”

Focus on core competency and organic growth

We tend to avoid “diworsifiers” or serial acquirers. Both cases tend to increase management costs and decrease capital efficiency in the end, unless an extraordinary capital allocator is in place. Then we should recognize that corporate managers like Buffett and Munger are a rare species, and so is Berkshire Hathaway.

Defensiveness and predictability

When it comes to equity investing, protecting the downside is usually more crucial than harvesting the upside. Our ideal investments are businesses that can survive and thrive during any economic conditions. Products like consumer staples (e.g., Church & Dwight (CHD)) that generate repeatable, small-ticket, every day, business-to-consumer sales provide long-term visibility on the company’s future cash flow for investors.

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway, Hermes, Domino’s Pizza, Facebook, MasterCard, Credit Acceptance, Philip Morris, British American Tobacco, Rollins and Novo Nordisk.

Urbem's 'Quality Strategy' Series: The Qualitative Traits

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