Quality Investing
Quality Investing

Quality Investing

To achieve sustained high returns on capital requires possessing features that protect returns from competition; namely, competitive advantages. Identifying what these competitive advantages are and understanding their sustainability is an essential part of the quality investment process. (Location 394)

Three elements drive corporate cash return on investment: asset turns, profit margins and cash conversion. (Location 398)

net income as a percentage of shareholders’ equity. (Location 403)

Measures such as return on invested capital (measured as net after-tax operating profit divided by invested capital) (Location 409)

Gross profit margin demonstrates competitive advantage: (Location 436)

Setting inflation aside, companies able to increase prices without corresponding increases in cost (or reduction in unit volume) have substantial pricing power. (Location 506)

Pricing power exists when customers are insensitive to price increases. (Location 508)

Mix-driven growth is highly valuable, entailing limited capital expenditure and only modest increases in working capital. But it is inferior to pure price-driven growth because it usually requires some increase in production costs. (Location 512)

However, cyclical growth poses analytical challenges: at some unpredictable point, a cyclical upswing reverses due to increased supply or reduced demand, at which point earnings and share prices tend to decline. (Location 527)

Whereas cyclical growth refers to episodic expansions, structural growth refers to more permanent expansions supported by persistent trends deemed likely to endure. (Location 533)

Despite this, there are a number of long-term trends that are more likely to prove sustainable than others, ranging from disease prevention to urbanization and aging demographics in developed markets. (Location 536)

Little14 found no relationship between growth rates achieved by any given company in one five-year period and those achieved in the next five years. (Location 544)

The probability of this is greater for companies in the ten to 15% earnings growth range than in the higher, hyper-growth ranges. (Location 556)

return on capital, which displays far greater persistence and is therefore a more reliable indicator of future growth. (Location 558)

Good managers have long-term vision for a business and the tenacity to realize (Location 582)

Good managers are never satisfied, but are instead driven by an indefatigable and passionate quest for improvement. (Location 588)

They found that “award-winning CEOs subsequently under-perform both relative to their prior performance and relative to a sample of non-winning CEOs
 (Location 596)

It also means being candid and speaking in a straightforward professional manner rather than indulging in the elliptical spin politicians favor. (Location 608)

Knowing the competition and understanding how it behaves is therefore vital to assessing the durability of competitive advantage. (Location 624)

Good examples occur amid mini and partial monopolies, which we discuss at the start of this section. (Location 627)

Real monopolies tend to be sizeable, rare, and disliked by governments. (Location 632)

Mini-monopolies are about the real choices customers have at the time of decision rather than theoretical choices. (Location 634)

Software upgrades and maintenance contracts typically sell at a high price compared to the cost of production. (Location 645)

When a company makes products that yield unique customer benefits, it creates some sort of mini-monopoly. (Location 646)

The most common form of broken competition is localized supremacy: (Location 652)

reflect its insuperable position in that market,23 itself a function of significant logistical barriers to entry. (Location 654)

Another form of broken competition is linked to switching costs. (Location 657)

For some companies, the economics of partial monopoly are so compelling that there is greater value in the back-end than the front-end. (Location 659)

Even when it comes to market share, the pairs differ. Coca-Cola clearly dominates over Pepsi, while Boeing and Airbus share their market pretty evenly. (Location 673)

In contrast to the soft drinks industry, the aircraft industry sells to a concentrated industrial customer base and every individual sale is negotiated hard. (Location 677)

Sometimes what seems to be a competitive market is rather a latticework of smaller monopoly-like structures where all participants extract high profits. (Location 680)

When a company only has one competitor, it quickly becomes a corporate lightning rod. It can easily become a corporate obsession to beat the other company all the time. (Location 681)

Beating multiple competitors all of the time is impossible, so companies tend to focus on fighting weaker competitors whilst leaving the stronger ones alone. (Location 684)

As a general rule, an oligopoly is preferable to a fragmented and volatile competitive landscape. (Location 687)

Finally, we tend to prefer the leading players in oligopolistic markets – especially in industries where competitive advantages in areas such as R&D and A&P are enhanced by market leadership. (Location 689)

barriers to entry are (Location 692)

However, industries with low barriers to entry may still have high barriers to success and scale – just look at the restaurant industry. (Location 692)

numbers, the sheer frequency of new entrants can eventually lead to one of them becoming successful and disruptive. (Location 694)

The consequence is that larger firms must often spend substantial sums acquiring upstarts just to maintain their competitive position. (Location 696)

The global confectionary industry is a good illustration. Of the six major firms, two are privately held (Mars and Ferrero); two are controlled by founding families or their foundations (Lindt and Hershey); and two are part of large conglomerates (NestlĂ© and Mondelēz). (Location 701)

attractiveness. In many industries, small price wars and market share battles will occasionally erupt. (Location 704)

Given the inevitable risk of any given company in any industry behaving destructively, we prefer companies in industries with the ability to snap back to rationality and stability. (Location 706)

While CEOs might have a three- to five-year perspective on a company, families think in generations. (Location 710)

Take the case of partial monopolies, where upfront sales generate long-term monopolistic profit streams. (Location 712)

While customers are quick to embrace price cuts, they fight price increases. (Location 719)

Discounting can be seductive in the short term: it boosts sales, enables companies to hit their profit targets, and even brings gains in market share. But it is dangerously addictive. (Location 721)

Having taught consumers to buy in bulk on sale is also one of the reasons why Coca-Cola struggles with profitability in North America. (Location 725)

if there are any particularly weak members, whom we call share donators. (Location 730)

hearing aid business (now in private equity hands).25 Another category includes smaller companies unable to scale up as an industry consolidates or globalizes – although not all of these surrender share routinely or readily. (Location 735)

To assess the likely future stability of a given industry, we will always look at its history. (Location 742)

Where companies talk about peers in respectful terms, the competitive behavior often reflects this. If the language used is dismissive or aggressive, the risk of mutually destructive behavior increases. (Location 744)

Financial and intellectual capital is drawn towards ideas that can change the world and which have the potential to make big money fast. (Location 751)

After introducing each – intangible benefits, assurance benefits and convenience benefits – we consider how different customer types respond to them. (Location 759)

Many consumer products pose the parachute scenario. Another company may offer a lower cost option, but the consequences of failure are seen as (Location 804)

For customers, the value of knowing – or believing – that they are choosing the most reliable or highest quality product can translate into a highly sustainable willingness to pay a premium price. (Location 806)

While customers know that this will result in a higher cost, they are willing to pay extra for reliability. (Location 809)

A new low-cost provider with no reputation will often lose to a higher cost provider with a good track record. (Location 812)

When parents buy baby food, a well-known brand like Nestlé’s Gerber provides assurance that the food is healthy and safe. (Location 814)

Farmers pay a premium for tractors from manufacturers such as John Deere because they offer time-tested quality products, fearing the risk of equipment failure on harvest results. (Location 816)

To compete with reputation is almost impossible, no matter how much money is staked on it. (Location 818)

They may not offer the cheapest or tastiest food, but neighbors pay for proximity. (Location 843)

This refers to sales models that position companies to best serve customer needs by offering convenience and efficiency. (Location 846)

A strong sales force can provide such a benefit, which is especially valuable for complex products where the salesperson assumes the role of advisor. (Location 848)

pays to distinguish between two broad groups: retail consumers and corporate clients. (Location 851)

consumers are more willing to splurge on items offering intangible benefits, particularly for smaller purchases. (Location 853)

As a rule, the larger a company is, the more objective its purchasing decisions; it will focus on direct cost savings increases and the willingness to pay for intangible or convenience benefits decreases. (Location 856)

Second, sellers tend to fare least well on products sold to corporations through bidding processes or organized negotiations where extensive product comparisons spell intense competition among suppliers that drives price down. (Location 862)

to the concept of ‘total cost of ownership’. (Location 865)

measurable production cost savings can be priced to reflect such benefits. (Location 866)

Software is a great illustration: while there are cheaper alternatives to SAP, it dominates partly because customers know that switching is painful and expensive, in terms both of direct cost and business disruption. (Location 868)

Similar to the case of retail customers, the prevalence of risk aversion among corporate buyers gives a clear advantage to products sold for their quality assurance benefits. (Location 871)

But this particular competitive advantage is hard to translate into further growth. (Location 875)

but the advantage is not scalable – there is no guarantee of being the sole licensee on any new beaches. (Location 876)

A product offering superior benefits for customers will have a competitive advantage and should yield above-average economic returns, but having just one product in this category is usually insufficient to sustain a competitive advantage. (Location 882)

the technology advantage is significant enough, the next question is how a company can keep churning out better technology than its competitors. (Location 887)

The simplest route is outspending rivals on R&D. Scale can also build barriers to entry that deter smaller rivals. (Location 889)

But since longevity is a more durable competitive edge, the race is more often won by the surest rather than the fleetest. When the pace of research is more measured, development typically unfolds in small increments and through relatively complex improvements. (Location 895)

Since incremental innovation is usually complex, it is more reliant on deep product knowledge that further entrenches long-established industry members: leaders stay in the lead. (Location 897)

Since then, improvements have come from incremental changes in materials, coatings, and design. (Location 900)

Not a revolution but a huge gain for end users, as airline fuel costs amount to one-third of total expenses. (Location 903)

Even supposing that a brilliant and well-financed innovator could perfect a new engine with 10% greater fuel efficiency, getting it to market would take years. (Location 905)

Moreover, jet engines are often sold at an upfront loss in order to generate service revenue – adding yet more years for new entrants to recover costs. (Location 906)

Advantages in data collection and manipulation can often produce powerful competitive advantages. (Location 908)

it remains a challenging edge to sustain. (Location 911)

Only a handful of companies have maintained technological leadership over time. Many faded into obscurity as the competition caught up or the direction of technological development shifted. (Location 912)

Ironically, when network effects are too strong, they may backfire. (Location 951)

Distribution as a competitive advantage means that a company’s route to consumers is more effective than its rivals’ for an otherwise equivalent product. (Location 958)

would take considerably more than a cheaper price from a rival manufacturer to induce the retailer to switch or alter its product mix. Rivals can offer lower prices, but a retailer faces risks: the relationship with the new manufacturer may not turn out as well or customers may like the alternative less. (Location 962)

Large retailers know their size and value to manufacturers. (Location 966)

In this case, having exceptionally strong product offerings that customers really want matters greatly. (Location 967)

The need for a service network creates a chicken-and-egg challenge for manufacturers. If customers don’t buy a product unless they know it will get serviced, companies may have to invest in a service network in order to sell. Having a service network running at low utilization, (Location 969)

Identifying, or even constructing, a quality company would be simple if these building blocks were all uniform – but the reality is much more complex. (Location 974)

Conversely, short-term vagaries can mask the solidity of other corporate structures. (Location 977)

To make the service model work, therefore, companies must successfully compete against such alternatives, meaning converting new equipment sales into service contracts. (Location 1022)

They often enter into sizable multiyear total care contracts with large airline customers to have engines serviced and parts replaced. (Location 1025)

The more significant the results of breakdown, the more likely owners are to buy original spare parts and purchase service contracts offered by the manufacturer. (Location 1027)

Another source of strength for the service model arises when the breakdown of a piece of equipment is likely to cause economic disruptions for its owner. (Location 1031)

Ship owners are therefore likely to put a premium on regular service and speed of repairs. (Location 1033)

The longer equipment remains in use, the longer it will require service and spare parts. (Location 1036)

The issue is how much annual recurring revenue can be expected, as a percentage of upfront annual sales. The bigger the percentage and the lengthier the time span, the better. (Location 1039)

When the cost of switching is low, customers soon migrate to cheaper options. (Location 1044)

the dominant competitive dynamic is to become the low-cost producer rather (Location 1045)

Subscription and service revenue tends to require little capital investment to support (Location 1064)

The combination of potentially negative working capital, rapid cash flows, and low capital expenditure to support growth is rare in business – but is a common feature of the recurring revenue model. (Location 1067)

as a signifier of quality, recurring revenues should be an overriding feature of the economics of the business – a trait we see in companies as seemingly diverse as Atlas Copco, Dassault Systùmes, Rolls-Royce and KONE. (Location 1070)

The margin on the upfront sale can be low, but sales typically secure years of annuity-like service revenue at a high margin and high return on capital (the ‘attach rate’ for KONE in developed markets is more than 90%). (Location 1087)

In one such type of bundling, the middleman is both a salesman and an expert, say a dentist recommending an implant or even a brand of toothpaste. (Location 1108)

For complex products or those that are difficult to install or consume, professional training is a compelling lock-in strategy. (Location 1132)

Since then, related technology has evolved to put an ever-increasing portion of the plumbing behind walls, to save space and for a better look. (Location 1139)

Geberit’s tactics enrich its relationship-based strategy in several distinctive ways. (Location 1149)

on-site if required. The program builds loyalty through product familiarity and saves plumbers the time and cost of apprentice schooling. In a typical year, (Location 1150)

This long-term product dependability enables Geberit to protect and promote plumber reputations. (Location 1153)

Many large industries are served by niche suppliers whose services or products may represent a relatively immaterial proportion of that industry’s cost base, but which are crucial to its successful operation. (Location 1168)

Companies in such niches benefit by extracting part of the economics from every unit of volume in a larger, often relatively stable, industry. We call them toll roads. (Location 1172)

Also designed to bring order to credit markets, the industry’s stability and related barriers to entry are illustrated by the fact that it survived, basically intact, despite considerable rating errors in the years leading up to the financial crisis of 2008. (Location 1177)

They offer particular value when risks of error are high, both from the direct consequences of failure – such as misallocated capital or injuries – and from the second-order effects of harm to reputation or legal liability. (Location 1180)

In finance, the proliferation of Microsoft’s Excel software illustrates an arc leading to the toll road: from school to basic training at firms to the corner suite, finance professionals and many people in other fields learn it, master it, and rely upon it. (Location 1188)

Magic ingredients manifest in many settings. In the food and beverage industries, take enzymes, flavors and fragrances. (Location 1196)

So companies tend to pay up for oxygen, preferring to buy only from the few big reputable companies that dominate this toll road. (Location 1199)

For one, the absolute cost of Chr. Hansen’s product is low. (Location 1216)

Furthermore, cultures tangibly affect food flavor and texture. (Location 1219)

Toll-road companies are typically oligopolies, not monopolies. While customers (and governments) perceive value from few producers versus innumerable rivals, a sole supplier presents a cost to competition that is too great to pay. (Location 1232)

but when combined with enhancing features, the pattern can be compelling. We call this low-price plus. (Location 1239)

However, their pricing strategies alone do not explain either the success or durability of the model. Rather, the pattern combines low pricing with protection against the competitive vulnerability it creates. (Location 1242)

Companies that can successfully forge a price-led model into a brand reputation for thrift go a long way to breaking the curse of low-cost vulnerability (Location 1246)

the first being a degree of product differentiation. (Location 1248)

Low-price-by-name offerings need to be both similar and different: IKEA furnishings must be fairly standardized but still distinctive. (Location 1253)

lets companies create products that can be sold at attractive prices without giving customers the ability to establish whether it really is the best deal in town. (Location 1254)

coordinated in a complex fashion, at considerable cost. The model depends on continuous and rapid response to shifting demand, meaning understanding changing consumer preferences, having control of the supply chain, managing inventory effectively, and deftness in distribution. (Location 1258)

True, as technology and supply chain automation commoditizes, these business models may become more vulnerable. (Location 1261)

portable wooden packing platforms – were first used for stocking merchandise in deep-discount retailers but are now a common sight at many supermarkets. Low-cost airlines like Southwest pioneered shorter aircraft turnaround times, but traditional airliners soon followed suit. (Location 1268)

low-cost squared companies construct a business model, organization, and culture that drives low cost in each step of every process throughout the operation. (Location 1270)

The bedrock of Ryanair’s spectacular growth is being the lowest-cost provider – by a wide margin – in a legendarily inefficient and uneconomic industry. (Location 1286)

Lower cost of funding enables a bank to underwrite less risky loans and still make a healthy margin. (Location 1324)

conditional pricing power: a company enjoying pockets of power due to select but recurring sales contexts. (Location 1381)

Similarly, companies boasting loyal middlemen who impose effective monopolies likely enjoy a degree of pricing power. (Location 1383)

This often occurs in industries with substantial volume growth and significant innovation. (Location 1393)

Such legacies are impossible to replicate: no amount of capital can reproduce such a history. (Location 1411)

Superior innovation from competitors diminished brand appeal. (Location 1458)

Scale can be a crucial facet of a brand’s success, providing advantages in marketing and distribution. (Location 1462)

Scale enables a company to control its own distribution, or make it the supplier of choice for distributors. (Location 1466)

change the color or shape of Oakley sunglasses and some people will discard their old pair and buy a new one to keep up with fashion. (Location 1475)

Two of the best known examples of this are Procter & Gamble and Unilever. (Location 1487)

While not an ironclad rule, we believe that a portfolio of personal care products or luxury brands is generally superior to a portfolio of food brands. (Location 1489)

Companies with high gross margins have more to invest in tactics to defend and grow their business, in areas such as R&D, A&P, or distribution. (Location 1503)

The path to ‘premiumization’ is often smoothest for products associated with social status or those conferring health advantages, where a higher price is often perceived to yield a greater benefit. (Location 1518)

Assuming customer appetite exists, the next question is how sustainable innovation can be. (Location 1527)

such as with basic calculators – or where there was a finite limit in the first place; there is only so much you can do with a cereal box. (Location 1528)

Categories that have not made significant advances during the past five years are less likely to produce sustained and valuable innovation in the future than those that have made substantial progress during that time. (Location 1529)

or Colgate’s strong track records of innovating in apparently humdrum sectors from toothpaste and household cleaning products to cold remedies or foot care. (Location 1533)

Incremental innovation generally tends to produce more predictable revenue growth. (Location 1546)

Moreover, incremental innovation tends to sit better with customers. Annual price increases of 5% for corresponding improvements become routine; abrupt price increases by a company with no track record of improvements provoke critical customer scrutiny about the price-value mix. (Location 1549)

Under the right conditions, forward integration can be hugely valuable. There are several types of forward integration, including store ownership, franchising, licensing and internet selling (e-tailing), each of which we examine below. (Location 1582)

Forward integration gives companies more influence over customer experiences. (Location 1587)

In retail stores, clever merchandising can stimulate customers to trade up and explore new things, as they try on clothes or smell perfume. (Location 1589)

Angeles. With a shortage of such locations available, it can take years for newer brands to build the kind of store-front offering needed to give a brand the desired cachet. (Location 1595)

Companies that control their own stores and infrastructure depend less on the kindness of strangers to promote the company’s benefits. (Location 1596)

For example, the world’s leading sunglass manufacturer, Luxottica, (Location 1600)

In its purest form, a franchise-based business provides growth funded by third parties – franchisees – and theoretically infinite returns on capital. (Location 1603)

to put the Holiday Inn flag above their hotel door. The franchisees, in turn, gain access to the branded firm’s well-established central booking system, which drives the majority of sales. (Location 1607)

Franchisor margins are also high: InterContinental Hotels Group boasts EBIT margins exceeding 80% in its franchise division. Once critical mass is established, the incremental profit contribution from additional franchised revenue is substantial. (Location 1611)

First, the underlying business needs powerful economics: strong enough for a third party to make an attractive return even after paying a fee to the brand owner. Second, there is a minimum scale requirement: the company must have the infrastructure to support a franchise system and the financial firepower to support a brand with A&P. (Location 1613)

The shift allowed the company to leverage its manufacturing prowess more effectively and profitably through increased control of customer relationships. (Location 1638)

Luxottica’s forward integration increases profitability, since less value from design, manufacturing and brand ownership leaks away through the chain. It lets the company build brand awareness and dictate trends, (Location 1644)

Owners of the licensed brands cite distribution capability as one of the main reasons that they are drawn to Luxottica. (Location 1647)

Its platform facilitates superior acquisition synergies compared to rivals, regardless of deal type. (Location 1650)

not always confer such significant benefits on manufacturers. It tends to increase the fixed cost base, impairing needed flexibility for companies in volatile industries or with weak brands where demand fluctuates. (Location 1655)

company with better products (in terms of quality and/or price) and superior execution should regularly attract new customers from competitors and widen its reach among existing consumers. (Location 1662)

Take industries such as insurance and bank lending. (Location 1676)

The risk from such behavior may not appear for years when defaults occur, as the credit default swaps at the heart of the 2008 financial crisis highlighted. (Location 1677)

While quality companies should still gain share over the long run, in these industries they likely cede share during economic booms and gain during economic busts. (Location 1680)

While rivals struggle, Fielmann runs an optician training academy and trains 3,000 eye care professionals annually, (Location 1707)

History is littered with examples of impressive domestic franchises that were eroded by the encroachment of foreign rivals. (Location 1715)

global industry leadership, we are referring more to product differentiation and business model than scale. (Location 1723)

While Rolls-Royce will not win every battle, it always has a good shot. A focus (Location 1725)

One way of assessing the durability of a competitive advantage is to invert the analysis. (Location 1862)

Such analysis often reveals idiosyncrasies that can be instructive in assessing a business’s quality. (Location 1864)

All of that investment has generated proprietary technology that would be difficult to match. (Location 1871)

Start-ups in this field would also have to overcome the considerable attachment that manufacturers like Airbus and Boeing have to their stalwart suppliers. (Location 1872)

are not the only routes to achieving the attractive economic characteristics of cash generation, high returns on capital, and growth. (Location 1908)

In these industries, products tend to be uniform and significant capital outlays are necessary for production. (Location 1932)

Expansions can last so long that most participants and many observers begin to believe that a structural change has occurred to eliminate the cycle. (Location 1934)

In supply-demand industries, some companies may command competitive advantages by being low-cost producers. (Location 1940)

Many companies have customers facing cyclicality in end-markets, meaning that demand for their own products fluctuates, but not necessarily price levels. (Location 1945)

business that is solely linked to customers’ capital expenditure makes for a much more complicated investment than one linked to their operating costs. (Location 1949)

For a company whose profits are dependent on such capital expenditure, it is extremely difficult to predict results. (Location 1952)

On the other hand, for a company whose profits tie to customers’ operating costs, cyclicality poses less risk of disruption and remains relatively predictable. (Location 1956)

When oil prices fall, producers still produce. So long as production is substantially maintained, suppliers of products tied to production and operating costs typically face less disruption from the cycle. (Location 1958)

So companies with most of their profit pools from flow products tend to experience less profit erosion during downturns. (Location 1961)

First, even if companies sell to less cyclical industries, steady revenue streams from flow products are typically more attractive than those dependent on capex. (Location 1964)

Second, spending on flow products tends to invite less customer scrutiny. Capital investments, whether on a drilling rig (Location 1967)

Many find they have been overpaying suppliers. After all, most suppliers to cyclical industries are adept at aligning pricing with customers’ budgeting. (Location 1973)

Downturns can even affect flow products. Some customers cut costs by stretching out equipment maintenance schedules and deferring overhauls or repairs. (Location 1976)

sacrificing reliability for cost. (Location 1978)

Amid cycle peaks, revenue growth rates and margins are usually elevated, but it is difficult to be sure by (Location 2030)

Big changes tend to favor quality companies over weaker counterparts. With superior products, better economic characteristics, and often stronger management, they can often capitalize on the challenges of cyclicality. (Location 2044)

Exemplars include many of the investments made by Warren Buffett and Berkshire Hathaway during the depths of the credit crisis of 2008, including extremely lucrative convertible preferred stock in General Electric (US) and Goldman Sachs, and a valuable (Location 2051)

But, at least for capitalists, innovation is two-edged: while great improvements create new fortunes and even new industries, they often decimate others. (Location 2057)

Among the most important questions we ask when investing is whether a company’s products will still exist in a similar and relevant form ten years hence. (Location 2060)

Small-scale innovation, like improved product packaging or safety, usually adds value and poses modest risk. (Location 2068)

With every shake up, some great businesses are destroyed while others flourish. But it is usually easier to identify innovation’s losers well before picking the long-term winners. (Location 2070)

that the ongoing trend toward online content would disrupt the economics of print newspaper publishers but even today it is not entirely clear how the historical profit pool will be split among consumers, new entrants, and incumbents. The same thing is happening in large parts of retailing with the emergence of dominant stars like Amazon. (Location 2071)

Infrastructure built around a certain method must be changed, yet it is not always obvious how to adapt. In the news business, for example, the trade-off – still unresolved – centers around whether to put online content behind paywalls, offer it free, or use some tiered combination. For traditional retailers, balancing store network pricing and mix with online pricing and mix remains perplexing. (Location 2077)

Given the unpredictable nature of rapid innovation, industries prone to it are unlikely to contain many quality companies. (Location 2084)

Whenever a company depends significantly on factors outside its control, risk rises. These (Location 2116)

We refer to products that rivals push to challenge that advantage as good-enough goods. The leading (Location 2190)

By offering similar products at lower prices, chains steer consumers to focus on price rather than quality. (Location 2192)

In a word, competition. The dental implant product is not especially complex. (Location 2224)

They became more comfortable that the cheaper alternatives – previously dismissed as inferior and less reliable – got the job done. (Location 2227)

some dentists made higher margins using lower-cost options, by charging the same price for the procedure irrespective of implant used. Since 2007, market volume for implants has expanded, but (Location 2230)

battling short-term thinking; conquering prevailing preferences for ‘hard’ numerical data over subjective assessments of quality; accepting that quality companies are not always the most exciting investments; and accepting that quality stocks will often appear to be expensive. We discuss each challenge in (Location 2252)

When participants measure results by the quarter or year, it is unsurprising that managers and investors concentrate on short-term outcomes. For publicly traded companies, the stock market offers a continual reckoning which entices participants to make investment decisions every day. Of late, many are even tempted by flash trading technologies to make such adjustments in matters of minutes or seconds. Information markets (Location 2258)

concept of compounding is one of the most important and valuable ideas in the world of business and investing. (Location 2269)

sustainable long term and available at a fair price, such a company would be far more appealing than most. (Location 2274)

So taking the long term is profitable, but challenging. (Location 2279)

Deeply cyclical sectors lacking strong steady returns on capital or with thin margins are anathema to quality investors. But share prices of such companies often benefit when markets trade certainty for hope. (Location 2289)

When markets favor such firms, a quality-focused portfolio will likely deliver comparatively weaker returns. (Location 2291)

This way of thinking dovetails with the notion of market efficiency, where undervalued stocks are both hidden and rare. (Location 2320)

Quality companies often lack this cherished pot-of-gold characteristic: they tend not to have products that promise to revolutionize the world. (Location 2322)

Worse, their quality is often, to some extent, already appreciated. Many investors would agree that HermĂšs or L’OrĂ©al are outstanding companies. (Location 2324)

Successful quality investing, therefore, sometimes requires avoiding the temptation of apparently exciting investment discoveries. (Location 2328)

Quality investing is best conceived as a ‘bottom up’ exercise in the sense of focusing primarily on a company and its industry – the firm-specific or microeconomic factors. While many investors share this approach, a good portion also engage in ‘top-down’ analytics by looking at the broader environment, considering the state of international trade, the rate of inflation, or the relative strengths of currencies. (Location 2336)

Given the arbitrary nature of many political decisions, even the most expert analysts struggle to predict how a government’s actions might impact a particular stock. (Location 2368)

Many investing mistakes arise from an illusion of predictability, which are especially acute in any rapidly-changing industry, such as technology. (Location 2370)

Debt can be seductive because even investors wary of excessive leverage can be deceived into stressing its upside more than its downside. (Location 2383)

Amid periods of economic expansion, the operating leverage enables growing revenue at lower cost, enabling cash flows that comfortably cover repayment of borrowed money. (Location 2390)

and failure to appreciate when a once-great company is falling from grace. (Location 2401)

Companies rarely deteriorate from great to good in a single quarter or year, but rather decline gradually over a few years or more. (Location 2408)

Our own research among European companies indicates that one-third of those issuing large profit warnings (measured as causing a stock price drop exceeding 10%) issued another, usually larger, profit warning within one year.37 (Location 2412)

For many fallen angels, overall deterioration generally begins with small things not going according to plan: growth not materializing, unexplained pressure on margins, more discussion of competitive pressures, or gradual increases in capital expenditure. (Location 2417)

triumphant roll-outs, Tesco built huge supermarkets which attracted customers from less developed retailers and more traditional channels. (Location 2432)

exciting for the management team, but drained focus, management resources, and capital. (Location 2436)

Tellingly, in 2011, long-standing CEO Terry Leahy left Tesco, at the height of the company’s UK stature. (Location 2444)

in other words failing to sell ahead of decline. (Location 2451)

It is tempting to interpret adversity as transient – to see sagging growth as a blip rather than structural, or a new competitor as unthreatening to a company’s core business. (Location 2452)

Firstly, technological changes driving market alterations are often more serious than they initially seem, especially in consumer or retail channels. (Location 2454)

This teaches us to scrutinize and question a company’s ability to make the changes necessary to protect its business model. (Location 2456)

Finally, if a company’s customers are getting poorer, the company will soon follow, as struggling customers reduce budgets. (Location 2460)

As the proponent engages with the critique, everyone listens for a “yes, but” – an acknowledgement of difficulty followed by a negating qualification. (Location 2465)

financial reports often contain innumerable subtle clues about the sustainability and predictability of earnings growth, cash flows, and returns on capital. (Location 2474)

one-in-five public companies misrepresent earnings by an average of 10%.39 (Location 2477)

an over-appreciation of things already owned compared to other opportunities. (Location 2510)

One strategy to combat this is to ask whether, with a fresh start, you would still buy the same company today. (Location 2515)

A quality investing strategy, therefore, emphasizes quality first, and valuation second. (Location 2522)

investing at almost any point during the decade would have been lucrative. (Location 2527)

it is equally rational to buy quality companies when valuations are attractive enough, despite seemingly high multiples. Just ask the many thousands of investors who have passed on buying Berkshire Hathaway shares – today priced at more than $200,000 – at any time since 1965. (Location 2550)

They respond accordingly, by hunting for stocks that will outperform the market in the coming quarters or year or two. (Location 2559)

Although on a one-year view, nearly 80% of stock price moves are explained by changes in multiples,50 the driver of longer-term stock returns is earnings growth. (Location 2562)

Focusing on such businesses reduces the chances of error in cash flow forecasting and therefore the risk of permanent loss of capital. Such an approach does not prevent error or loss, of course, but reducing the frequency and severity of losses is as important to long-term returns as picking winners. (Location 2573)

Successful execution of such an approach requires an inquisitive mind, a desire to read widely, and a willingness to gather information broadly. (Location 2585)

Checklists can help focus rationality and confront the important questions about an investment. Given the complexities, no checklist can capture every nuance or draw attention to every risk. (Location 2594)

valuation. A good checklist should enumerate all the desired attributes for an investment and, ideally, the steps required for full due diligence. It should also incorporate lessons learned from previous mistakes and be regularly updated accordingly. (Location 2597)

As summarized by Daniel Kahneman in Thinking, Fast and Slow, cognitive errors such as confirmation bias, hindsight bias, and outcome bias are rife in the investing world. (Location 2605)

among the greatest challenges for any investor. A primary technique for mitigating the influence of biases is to focus as far as possible on the process rather than the outcome: (Location 2607)

Benefitting from attractive industry structures and unique patterns of competitive advantage, quality companies deliver sustainably higher growth and achieve strong returns on capital over the long term. (Location 2617)