Creating a Business Quality Framework. (Part 1)



Preface

As an asset owner or allocator, it's crucial to understand the nature of your underlying investments. When allocating to equities, you’re essentially owning businesses. It goes without saying that any allocator should aim to invest in “good” businesses—often described as a portfolio of high-quality, durable compounders. But what does that really mean?

At Pandi and the Patterson Family Foundation, a potential example of a “good” business would be the family's source of wealth: Cerner Corporation. Neal Patterson and Cliff Illig founded Cerner on a park bench in Kansas City, and what began as a small business eventually became the electronic health records used across North America today. If you asked them today what their success boiled down to, they’d likely say it was simple: quality and duration. While that is obviously an oversimplification, the answer lends itself to a follow-up question—what exactly is quality?

I took a value investing class during my last semester of college. One of our assignments was to craft a simple description of a “quality business”, which was much harder to do than I initally expected it to be. What I came up with is as follows:

Across most industries, good businesses generally have two overarching characteristics: strong earnings growth (gross margins, free cash flow, etc.), high returns on invested capital (ROIC), and manageable financial leverage. Factors that help create the aforementioned characteristics include competitive moats/barriers to entry (patents, network effects, high switching costs, etc.), sticky revenue/low churn rates, shareholder aligned management incentives, and efficient capital allocation (through reinvesting in operations, acquisitions, dividends, share buybacks, or paying off debt). We want to avoid businesses with excessive debt, within secularly declining industries, with permanently impaired balance sheets, or with impaired profitability.

The following is a framework that attempts to apply a quantitative lens to the question— what is a quality business?


A Durable and Wide Economic Moat:


A durable and wide economic moat is a critical factor in the long-term success and sustainability of any business. The broader and more enduring the moat, the better protected the company is against competitive forces, ensuring it can sustain profits and grow over time. Elements of a durable moat include, but are not limited to:

1. Customer Switching Costs and/or Loyalty

Customer switching costs refer to the financial, time, or effort-related expenses that a customer would incur if they were to change from one product or service to another. High switching costs create a strong incentive for customers to stay with a company, even if competitors offer similar products. This stickiness can be due to factors like the need for retraining, the risk of disruption, or loss of data in the case of software products. Additionally, customer loyalty, which can be built through superior product quality, excellent customer service, or strong brand reputation, acts as another barrier to competition. When customers are highly loyal, they are less likely to switch, even in the face of lower-priced alternatives.

2. Economies of Scale

Economies of scale occur when a company can reduce its per-unit costs as it increases production. This cost advantage allows larger companies to underprice smaller competitors, effectively squeezing them out of the market. Firms with significant economies of scale benefit from spreading fixed costs over a larger output, gaining purchasing power with suppliers, and optimizing production efficiencies. These cost advantages are difficult for new entrants to replicate, creating a barrier to entry and reinforcing the company's competitive position.

3. Network Effects

Network effects arise when the value of a product or service increases as more people use it. This phenomenon is particularly powerful in industries like social media, online marketplaces, and payment networks. For example, a social media platform becomes more valuable as more users join, because each new user increases the amount of content and connections available. As the network grows, it becomes increasingly difficult for competitors to attract users, as they are unlikely to offer the same level of connectivity or content. Network effects create a self-reinforcing cycle, where growth begets more growth, strengthening the company’s moat.

4. Assets/Manufacturing/Distribution Hard to Replicate

Some companies possess unique assets, manufacturing capabilities, or distribution networks that are extremely difficult for competitors to replicate. This could include patented technologies, specialized manufacturing processes, or exclusive distribution agreements. These assets provide a significant competitive advantage, as they allow the company to offer products or services that others cannot easily match. The difficulty in replicating these resources further strengthens the company’s moat, making it more resilient to competitive pressures and market changes.

Long Runway for Profitable Growth:


Several key factors that contribute to a company's long runway for profitable growth. Each element represents a critical aspect of business operations that, when effectively leveraged, can drive sustained revenue and profit expansion. Here’s a closer look at each factor:

1. Organic Volume Growth

Organic volume growth refers to the increase in sales or output that a company achieves through its existing operations, without relying on acquisitions or mergers. This type of growth is often a sign of strong customer demand, market penetration, and operational efficiency. Companies that consistently achieve organic volume growth can sustain long-term profitability by continually expanding their customer base and increasing sales within their current markets.

2. Core Price Growth

Core price growth involves the ability to raise prices on products or services without losing customers. This is often a reflection of a company's pricing power, which can stem from strong brand equity, high-quality products, or a unique value proposition. Sustained price growth contributes directly to improved profit margins and is a crucial component of long-term profitability.

3. Cross-/Up-Selling Growth Potential

The potential for cross-selling and up-selling represents opportunities to increase the average transaction value by offering additional products or services to existing customers. Cross-selling involves introducing customers to complementary products, while up-selling encourages customers to purchase more premium options. Companies that effectively implement these strategies can significantly boost their revenue and deepen customer relationships, extending their runway for growth.

4. Expected Industry Growth

The anticipated growth of the industry in which a company operates is a major determinant of its long-term prospects. Companies in industries with strong, expected growth trends have a natural tailwind that supports their expansion efforts. Being positioned in a growing industry can enhance a company’s ability to capture new opportunities and scale its operations.

5. Share Gainer

A company that consistently gains market share at the expense of its competitors demonstrates strong competitive positioning. Share gainers are typically more innovative, efficient, or customer-centric than their peers, allowing them to attract and retain more customers over time. This ability to outpace the competition is a key driver of long-term growth and profitability.

6. Attractive End-Market Dynamics

End-market dynamics refer to the conditions and trends within the final markets where a company sells its products or services. Companies operating in markets with favorable dynamics—such as increasing demand, limited competition, or supportive regulatory environments—are better positioned to achieve sustained growth. Attractive end-markets provide a fertile ground for expansion and profitability.

7. Beneficiary from Secular Themes

Secular themes are long-term, transformative trends that reshape industries and create new opportunities. Examples include digital transformation, sustainability, demographic shifts, and urbanization. Companies that align with and capitalize on these themes can experience significant growth as these trends unfold over time. Being a beneficiary of secular themes ensures that a company remains relevant and positioned for future success.

Reinvestment at High Rates of Return:


A company's ability to reinvest at high rates of return is essential for sustained growth and long-term value creation. Reinvesting profits effectively allows a company to compound its returns over time, leading to increased shareholder value. Each of the components listed contributes to a company’s capacity to generate superior returns on invested capital (ROIC).

1. High Reinvestment ROIC in Core Business

High reinvestment in the core business at a strong return on invested capital (ROIC) is a key driver of long-term growth. When a company is able to reinvest its earnings back into its primary operations and achieve a high rate of return, it maximizes the efficiency of its capital use. This reinvestment often goes toward expanding production capacity, enhancing product offerings, improving operational efficiencies, or deepening customer relationships. By consistently achieving high returns within its core business, the company ensures that its growth is both profitable and sustainable, making it a more attractive investment over time.

2. Ability to Enter New Markets at High ROIC

The ability to enter new markets while maintaining a high ROIC is another crucial factor for growth. When a company can expand into new geographic regions, customer segments, or product lines without diluting its overall return on capital, it demonstrates strong competitive positioning and strategic agility. Successfully entering new markets at high ROIC involves leveraging existing strengths, such as brand equity, supply chain efficiencies, or technological advantages, to capture new growth opportunities. This capability allows a company to diversify its revenue streams, reduce reliance on any single market, and sustain growth over the long term.

3. Ability to Grow through Accretive M&A

Growing through accretive mergers and acquisitions (M&A) is another powerful way for a company to expand its footprint while enhancing shareholder value. Accretive M&A refers to acquisitions that increase a company's earnings per share (EPS) or add to its value by generating a higher return than the cost of capital. Companies that are adept at identifying, acquiring, and integrating businesses that complement their existing operations can achieve substantial growth and competitive advantages. Accretive acquisitions often provide synergies—such as cost savings, increased market share, or access to new technologies—that enhance the company's overall performance and profitability.

Attractive Financial Profile:


These attributes are essential for identifying companies with strong financial health, stability, and growth potential. Each component contributes to a company's ability to generate consistent returns, maintain operational flexibility, and manage risk effectively.

1. Recurring or Stable Revenues

Recurring or stable revenues provide a solid foundation for a company's financial health. This revenue predictability reduces the uncertainty around cash flows, making it easier for the company to plan and invest for the future. Businesses with recurring revenue models, such as subscription-based services, tend to have more consistent earnings, which investors highly value for their lower risk profile.

2. Revenue Cyclicality (Peak-to-Trough)

Understanding revenue cyclicality is crucial for assessing a company's resilience to economic downturns. Companies with low revenue cyclicality tend to perform steadily across economic cycles, experiencing less volatility between peak and trough periods. These companies are typically more attractive to investors because they provide a buffer against economic uncertainties and market fluctuations.

3. High NTM EBITDA / EBIT Margins

High Next Twelve Months (NTM) EBITDA or EBIT margins indicate a company's efficiency in converting revenues into profits. High margins suggest that the company has effective cost controls, pricing power, and strong competitive positioning. Businesses with robust margins are better equipped to weather economic challenges and sustain long-term growth.

4. High ROIC / Tangible ROIC

High Return on Invested Capital (ROIC) reflects a company's ability to generate returns on the capital it employs in its operations. Tangible ROIC focuses specifically on returns generated from tangible assets, such as property, plant, and equipment. A high ROIC indicates that the company is using its capital efficiently to create value for shareholders, making it a more attractive investment.

5. NTM EBIT Growth

Next Twelve Months (NTM) EBIT growth refers to the expected increase in Earnings Before Interest and Taxes (EBIT) over the next year. Consistent EBIT growth demonstrates a company's ability to expand its earnings, either through revenue growth, cost management, or both. Companies with strong EBIT growth prospects are more likely to generate higher returns and command a premium valuation in the market.

6. High FCF as a Percentage of EBITDA

High Free Cash Flow (FCF) as a percentage of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) indicates that a substantial portion of the company's earnings is being converted into cash. High FCF is critical for maintaining financial flexibility, funding growth initiatives, paying down debt, and returning capital to shareholders through dividends or buybacks.

7. Margins or ROIC Expansion

Expansion in profit margins or ROIC suggests that a company is improving its profitability or capital efficiency. This could result from scaling up operations, improving cost structures, enhancing product mix, or leveraging competitive advantages. Margin or ROIC expansion signals to investors that the company is not only maintaining but also growing its financial strength.

8. No Uncertain or Hidden Liabilities

A company with no uncertain or hidden liabilities is more transparent and less risky. Hidden liabilities, such as off-balance-sheet obligations or contingent liabilities, can unexpectedly impact a company's financial position. A clean balance sheet enhances investor confidence and reduces the risk of unforeseen financial shocks.

9. Avoids Spending Capital for Uncertain Demand

Prudent capital allocation is a hallmark of an attractive financial profile. Companies that avoid spending capital on projects or initiatives with uncertain demand demonstrate financial discipline and risk management. This approach ensures that capital is deployed where it is most likely to generate strong returns, avoiding waste and reducing the risk of losses.

10. Appropriate Capital Structure

An appropriate capital structure balances debt and equity in a way that optimizes the cost of capital while maintaining financial flexibility. A well-managed capital structure minimizes financial risk, reduces the cost of borrowing, and ensures the company can access capital markets when needed. This stability is attractive to investors and supports long-term growth.


This concludes Part 1, click here to continue to Part 2.