By: Quilan Foster
“Beauty lies in the eyes of the beholder.” – Margaret Wolfe Hungerford
The idea of quality, similar to that of beauty in philosophy, is defined differently in business, depending on whom we ask. While investors often express their desire to hold on to quality businesses, it is difficult to figure out what they mean by this. There is no universal definition of quality – you must create your own. However, it does not matter whether we view quality as a subjective or objective concept, as we can get closer to the core idea of it by understanding what it is not.
A low-quality business:
Does not create value for society, customers, or its owners;
Does not employ scarce resources at their highest and best use, and;
Does not withstand the test of time
The main characteristics are value, resources, and time. A business cannot be deemed of good quality if it does not create any true value. If it does create value, the cost of creating that value should be lower than that of the total value created, or else, it would effectively be destroying value. Finally, a business that creates value should be using its resources efficiently and must be able to sustain such a process over a prolonged period of time or face the risk of being replaced by another firm vying to do the same thing.
Value Creation
Business originates from value creation. The purpose of a business is to deliver superior value to its customers in an efficient enough way to capture some of that value back through the form of profits.
To understand the concept of value, we can refer to Carl Menger, a founder of the Austrian School of Economics, who developed the Subjective Theory of Value. Under this school of thought, value is defined as the Perceived Use Value of a product by an individual who buys and sells it, as opposed to being fixed by the amount of resources that went into creating it.
The simplest way to measure value creation is through revenue generation. Revenue acts as a floor for the value created, as people who are willing to pay for a product must perceive a consumer surplus, or else, they wouldn’t transact. Therefore, not all value creation will be monetized by the business. Jeff Bezos does an amazing job explaining how Amazon creates more than it consumes in his 2020 letter.
Revenue is a measure of value creation – not profit. A company could create value without generating any profit (and many do), but it won’t do it for long. As an investor, you want to identify the companies that can create the most value for its ecosystem and look at qualitative attributes such as consumer surplus, pricing power, and optionality (potential to create new revenue streams).
Resource Efficiency
Delivering value is at the core of all businesses. What matters, however, is delivering that value in an efficient manner to capture some of that created value and ultimately create economic value for the business owners. Efficiency is about making the best possible use of resources and maximizing outputs from given inputs. It is easier to measure than value creation, as margins, capital employed, return on invested capital and other metrics used are quantitative by nature.
Quality companies are the ones that can operate at top-level efficiency, which will be reflected through their higher gross and operating margins and can use their invested capital to generate returns that are higher than their cost of capital.
Time Duration
Time duration is determined by a company’s ability to operate and compound capital for a prolonged period – surviving the test of time. Value and wealth creation are long-term processes. Going out of business or losing a competitive edge prematurely will destroy all future benefits derived from operating a business or holding onto an investment.
By its very nature, capitalism will lead to competition. We can view this through the lens of biology, where living things are vying for the same scarce resources and are subject to natural selection. They must evolve and adapt or suffer the consequences of extinction. The same principles can be used to look at businesses and better understand why some thrive in a competitive world while others fall out of favour or disappear altogether.
In a free market, any business generating abnormal profits will inevitably encounter competition. Quality businesses, however, can prosper regardless of that competition due to some attributes that distinguish them from their competitors. Having a moat, focusing on a specific niche, or other similar characteristics, ultimately all have one thing in common: they aim to extend the lifespan of the business.
As an investor, you want to look at companies that possess strong competitive advantages, operate in an attractive industry, and can survive through harsh economic conditions and adapt to the rapidly changing world.
By building upon these ideas, we can get closer to the core of what quality in a business is. A quality business would seek to maximize its value creation in its market, its efficiency in using its scarce resources, and its duration across time. Anything a business does that does not maximize these attributes would deduct from its total perceivable quality.
The way that quality in a company is perceived is through quantitative and qualitative attributes that investors can use to better assess the business.
Table 1: Ways That Quality is Perceived in a Business
Essentially, all attributes used to define quality in a business could fall into one of the three boxes. The better these attributes, the closer we are to having found a quality business.
Quality & Investing
“Investment success doesn’t come from buying good things, but rather from buying things well.” ― Howard Marks
For investors, being able to find and analyze quality businesses in the markets is only one part of the equation and won’t give them any edge over other markets participants. Quality businesses are usually the most sought-after by investors, implying that their valuations will tend to be higher than most other companies.
The key insight is that a quality business does not necessarily make it a good investment, and a low-quality business does not necessarily make it a poor investment. Price is the variable that links the concepts of business and investing together. Since the value of any business is ultimately derived by the sum of its future free cash flows (discounted back to the present), it implies that there is a maximum amount that should be paid for any investment. As Warren Buffet famously said: “Price is what you pay, value is what you get.”
Notes:
1. CA stands for competitive advantage.
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