The market’s best companies

This article appeared in the April 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Identifying top-performing businesses is not hard if you know what to look for. This article provides a simple checklist to spot great companies, and nominates 15 that fit the criteria.

Photo of Roger Montgomery By Roger Montgomery, Montgomery Investment Management

Everyone wants to make their fortune in the sharemarket and provided you are not in a hurry, you most definitely can. What many instinctively know, however, is that if you were offered the opportunity to give up some upside in order to protect the downside, you would.

Many studies have revealed that the pain of loss is felt twice as acutely as the joy of making a profit, yet the focus of most investors is on finding the winners rather than avoiding the losers.

Earlier this year, Dr Leah Kelly and Paul Umbrazunas wrote in Chris Cuffe's Cuffelinks newsletter: "…there should be more focus on minimising the 'points' lost rather than maximising the gains required. The reason is clear. Upon incurring a market loss, a larger return is required simply to get back to where you started.

As a simple example, consider the following two investors, both investing $10,000 at the end of May 2000.

  • Investor 1 invests $10,000 in the ASX 200. Here the volatility is approximately 12 per cent per annum.
  • Investor 2 is more conservative and invests $10,000, 40 per cent in the ASX 200 and 60 per cent in cash. Here the volatility is approximately 5 per cent per annum.

Both investors had a good time until September 2007, with about $30,000 and $20,000 in capital for Investors 1 and 2 respectively. Then disaster. Investor 1 was hit with a drawdown period that lasted from September 2007 until January 2009, culminating in a total loss of 49 per cent. Investor 2 did not escape unscathed; a total loss of 17 per cent was accumulated from September 2007 until January 2009.

To return to the equivalent capital balance before September 2007, the total required return for Investor 1 was 92 per cent and for Investor 2 it was 22 per cent.

We assume for this illustration that neither investor changed their asset allocation.

How long did it take them to return to breakeven? For Investor 1, six years; for Investor 2, two and a half years. As an aside, by the end of January 2014, the annual realised return since May 2000 for Investors 1 and 2 was 5.5 per cent and 4.7 per cent respectively. The realised annual volatility over the (nearly) 14-year investment was 13 per cent and 5 per cent respectively."

What Kelly and Umbrazunas revealed is that the deeper the losses, the longer it takes and the harder it is to retrieve those losses.

It also showed the importance of reducing exposure to what we might refer to as "landmines".

Finding the best businesses

The key is to find companies whose underlying businesses might help to mitigate the risk of permanent capital loss.

The very best businesses to own are simply those that have the ability to take large amounts of incremental equity capital and generate very high rates of return. Warren Buffett summed it up best when he said: "All we want is big equity and big returns on equity."

To generate those high returns sustainably, it usually helps that the company has something that is defendable against competition.

Also known as a "sustainable competitive advantage", businesses that have such characteristics are able to generate higher rates of return than their competitors, setting themselves, and their owners, up for a bright future.

The table below shows 15 Australian listed businesses that generate high rates of return on equity, while also suggesting their possible competitive advantages.

Company name

ASX code

Return on equity

Possible competitive advantage

ARB Corporation ARP 25.70% Brand/design/reputation
Corporate Travel Management CTD 20.12% Reputation/switching costs
Sirtex* SRX 22.60% Patent/reputation
SEEK* SEK 23.97% Network effect
REA Group REA 38.78% Network effect
McMillan Shakespeare* MMS 34.25% Switching costs
CSL* CSL 39.55% Patents/reputation
JB Hi-Fi* JBH 55.34% Low cost
Woolworths* WOW 26.78% Low cost/brand/logistics/geographic monopoly
Ainsworth Game Tech* AGI 29.27% Knowledge/experience
Breville Group BRG 26.51% Brand/design/reputation
Flight Centre* FLT 26.28% Footprint/reputation
Banks* ANZ/CBA/WBC circa 16% Oligopoly

Any cursory view of these companies' share price performances over the long term will also demonstrate the value of such returns and competitive advantages.

The best businesses have great economics, great prospects for sales and profits, and great management. They have high rates of return on equity, driven by sustainable competitive advantages, solid cashflow and little or no debt. They are run by first-class managers who think like owners and treat their shareholders as such.

Owners of such businesses, whether listed or unlisted, tend to do very well and you will do well if you can fill your portfolio with these businesses.

What makes a wonderful business?

A list of factors you should look for in a business (followed by some suggested companies to research) are:

  • Bright long-term prospects
    • (REA Group, Seek, Ainsworth Gaming, Veda, Ramsay Healthcare).
  • A high rate of return on equity driven by sustainable competitive advantages
    • (see stocks in Table 1).
  • Solid cashflow
    • (All of the above).
  • Little or no debt
    • (All of the above).
  • Wonderful management, with the company run by people who think like owners and treat shareholders as such
    • (Many of the above).

By our definition, a wonderful business is one that meets all these criteria. Many investors ask what to do if most of the criteria are met but not all of them. The simple answer is that the business is not truly wonderful. It is human nature to fear missing out, so when we think that we can profit from an opportunity, we will be tempted to grab it despite the fact that not every box is ticked.

The right response, however, is to resist the temptation and move on to the next opportunity, remembering that investing is not a game where you have to swing at everything.

In fact, investing is most sensible and usually most rewarding when patience and rationality are employed, rather than emotion. Simply move on and wait until the perfect opportunity presents itself. You will not run out of opportunities.

But if you swing too often and miss, you will run out of money.

Focus on the numbers

A business's economics and the performance of its management are broadly measurable by relatively simple arithmetic and by applying a sound framework. Therefore, wonderful economics can be determined with numbers, which makes your job a lot easier.

The long-term prospects of a business, however, are less able to be summarised with numbers. Instead, the assessment of a business's prospects for growth in sales and earnings requires some thought.

Businesses that have bright prospects for growth are to be sought out and prized and are generally worth more than those that don't grow. But growth is not essential; and some growth - where the company's return on equity is low - will hurt rather than help shareholders.

Working out whether a company has bright prospects for growth is also easier in some industries than others. For example, as Buffett noted:

"A business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee 30 years ago what would transpire in the television manufacturing or computer industries? Of course not. Why, then, should Charlie and I now think we can predict the future of other rapidly evolving businesses? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?"

And this from 1993: "At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cashflows."

In other words, prospects for Woolworths and the Commonwealth Bank, and other companies like them, will be easier to predict than, say, a small mining exploration company or a technology startup.

You will be much better positioned when you remember that the market is not always right, so treat it as a place to buy businesses rather than a place to trade stocks. Focus on value rather than price and be prepared to take advantage of the market rather than listen to it.

You will then be able to navigate your way past the companies that do not offer the best opportunity for high and relatively safe returns, either because they have inferior economics, people in management who don't think like owners, or doubtful prospects.

When it comes to assessing management, who is rowing the boat is important but not nearly as important as the boat they get into.

One major key is management's understanding of the importance of capital allocation. Should capital be retained and reinvested, or paid out as dividends, or used to buy back shares? Answers to these questions will tell whether management are working for you or for themselves.

Space precludes a full discussion about that topic here but you can find an entire chapter dedicated to explaining what to look for in my book,

An example: JB Hi-Fi

Knowing which businesses are great and which are mediocre is the relatively easy part of investing. (The harder part is buying them below fair value). Understanding a business is straightforward when you know what to look for.

It is not hard to conclude that JB Hi-Fi was a better investment than Clive Peeters. ("Clive Who?" I hear you ask.) When the guy at the Apple store tells you the cheapest place to get a Mac is at JB Hi-Fi, you have to conclude that JB Hi-Fi has some important advantages that keep people coming back. Indeed, consumers have told me they would rather wait until JB Hi-Fi has a product in stock than risk paying too much by being impatient.

The strength of JB Hi-Fi's brand, including its promise to consumers; the strength of its buying power and distribution systems; and commitment to run the business on the smell of an oily rag - all this gives the company a huge competitive advantage.

As such, JB Hi-Fi has set up a protective moat around its economic castle. By contrast, a mediocre company has no such advantage, no compelling reason for people to buy its product or service. Its customers arrive at the counter with a price and say, "This is the best price we can get from someone else - can you beat it?"

Are mining companies wonderful businesses?

The commodity business - which lacks any competitive advantage - has no option but to say "yes", otherwise it runs the risk of under-utilising its production capacity and its machinery sits idle. This is the antithesis of the business with a true competitive advantage.

The most valuable differentiator or competitive advantage is one that allows the business to simply raise the price each year without losing any business at all. The way to differentiate the value of the competitive advantage is by comparing the price of goods or services. The best businesses can afford to charge a higher price. Ultimately, being able to charge more is what matters.

This is one of the big things that investors, advisers and market commentators miss - because they are talking about, or trading, stocks rather than thinking about businesses. Most investors are consumers and so most investors have a reasonably good grasp of the things that drive consumer behaviour. You can tell in an instant that JB Hi-Fi has a stronger business than Clive Peeters (now defunct) ever did.

The hard part is being patient, waiting for the perfect opportunity and keeping your head when everyone else is losing theirs. Temperament is an important ingredient in investing, but unfortunately that was the domain of your parents, not this article.

As you are aware, Buffett built an epochal fortune through commonsense investing and became the world's richest individual. He said if you are not prepared to own the whole business, you shouldn't buy a little piece of it.

The reality is that you will make some mistakes - everyone does - but if you stick to businesses with high rates of return on equity, little or no debt, and those where you can identify a competitive advantage, you will minimise, to a great extent, the most important risk - that of a permanent loss of capital.

About the author

Roger Montgomery writes as Chief Investment Officer of The Montgomery Fund. Investors with $25,000 or more can access The Montgomery, which is rated and available on a wide number of platforms and wraps. Speak to your advisor or visit Montgomery.

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