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CHARACTERISTICS OF A GOOD COMPANY

And Yes, You Can Have a Good Company, but a Bad Stock!

Written by: Tim Moore, CFA, Portfolio Manager

INTRODUCTION
As with most things and people in life, not all are created equal. Same holds true with companies. With over 30,000 investable companies listed worldwide (nearly 60,000 public ones) compared to a need of only 45-70 in a diversified portfolio, how does a global portfolio manager nagate these waters? Knowing which characteristics to seek in a company is the epicenter of investment success.

WHAT MAKES A GOOD COMPANY?
STRONG MANAGEMENT TEAMS WITH A COHERENT BUSINESS MODEL AND STRATEGY
Finding this is more rare than one would initially imagine! I have met dozens of CEOs and CFOs who could not articulate or pinpoint their underlying business model and how it is unique. Management’s ability to develop a strategy and implement it can often he more important than the underlying industry fundamentals. A capable and devoted management team can make all the difference in separating stars from eventual duds. If top management cannot easily explain their company story and how they generate income or cash, then it is a red flag to avoid them. Management’s competence and operational knowh ow is vital. A premium is warranted for management which does not become distracted chasing irrational strategic fit ambitions.

BARRIERS TO ENTRY
Warren Buffett often refers to a “moat” as a prerequisite competitive advantage for investing in any company. This can include:

Being in a niche market that is not threatened by large incumbents.
having dominant or leading market share is appealing, such as being a Top 3 player or largest player in a fragmented niche with 50% more market share than the next largest competitor.
Mass market potential in their product or service also scores highly on a “moat or franchise-like” checklist.
Having First-Mover Advantage—the initial significant occupant of a market segment—and establishing strong brand equity or differentiated positioning in the minds of consumers.
Differentiation with an innovation or reliability of their product or service or even a highly regarded customer service reputation to create barriers against competitors or new entrants.
Underserved markets that are operating near full capacity (demand outstripping supply) also act as barriers.
economies of scale, regulation, customer loyalty, capital resources, research and development, branding, vertical integration (partici i)atO in most of the value chain to control quality and eliminate middlemen/wholesalers).
Cost advantage in production or servicing.
High switching costs (costly or delays for a customer to leave one company for another).

These all act as formidable barriers. No company will score perfectly on all of these. Nonetheless, the most appealing ones will demonstrate several of them over many years.

SOME PREDICTABILITY TO EARNINGS POTENTIAL
The more attractive companies have some predictable attributes like:

Recurring revenues or profits from consumables or Aftermarket services
More controllable margin drivers from a better position in the value chain
Better customer service or wider sales network reach
Dominant market share (the “go-to leader”)
An annuity or royalty revenue sti’am model
Less reliance on passing through input cost movements (not commodities)
A more Ilexible operating cost structure (quickly scaled back during tough times or enhanced easily to meet a demand resurgence)

HIGHER MARGIN COMPANIES
Firms that retain a higher percentage of their revenues over time are compelling. While operating and profit margins can vary sporadically due to some one-time expense or economic downturn, companies which uphold higher margins, while still growing revenues, are more attractive. This requires a unique value proposition, proper handling of expenses and being strongly positioned to maintain or grow market share. Think game-changing products or services which enlarge the overall addressable market like Apple iPods and iPads or Netilix instant delivery of streaming movies over the internet. Taking the extra step to “decompose” the margin drivers to learn what truly fuels expansion potential (i.e., volume, pricing power, acquisition boost, scalahility on a larger fixed-cost basis, purchasing power) is crucial for determining sustainahility versus only one-term benefits (i.e., foreign currency or derivatives boost, artificially low tax rate, unsustainable financial income). Requiring low reclLrring capital investment to grow is also vital in maintaining high margins (unlike airlines or autos).

HEALTHY BALANCE SHEETS
Companies with little to no debt are better positioned to prosper than those heavily indebted. Debt-laden firms are restricted from large internal investments like:

Research and development for new products or services
Marketing to grow awareness and brand value or Funding for sensible small tack-on acquisitions

Less debt nicans more flexibility when opportunities arise. I un herniore, companies with heay debt burdens unfortunately allocate too much of their operating profit to servicing interest expense. At some firms, 20-40% of operating profit is consumed by interest expense, preventing pass-through to retained earnings or shareholders. Leverage (too much debt) can clearly magnify gains in perfect economic conditions, hut can also become addictive for management teams — and dangerously become asymmetric during downturns. Not only will it then consume most of any operating profit in a recession, but it could also lead to unprofitable periods while concurrently limiting their opportunity set. It blocks the opportunity to steal market share when their competitors struggle. More often than not, investors are not compensated enough for a burdened balance sheet.

PRICING POWER AND ORGANIC GROWTH
Long-Term value creators can be truly uncovered by their ability to raise prices on their products and services even when commodity input costs are falling or during some minor economic slowdown. Sustainahility of these unique companies is predicated on a value proposition that can range from dominant market share, unique niche positioning, large purchasing power scale (for more discounts on their inputs or labor), better customer service, quicker and more appealing innovation rate (typically a function of effective research and development or marketing spending) and precision in their tactical execution of operational strategies.

How fast does the market think the company ean grow earnings?
What is that gap in growth pace versus your own expectations and why?

Corn panies that grow organically through pricing, volumes, market share steal or creation, internal investments or geographic expansion tend to outperform ones dependent on acquisitions for growth.

FREE CASH FLOW GENERATION
In theory, most stocks should be valued on their stream of future cash flows discounted hack at a rate for their cost of capital. Cash generation is vital to a company’s health and the prospect of being in an ongoing entity. Free Cash Flow (operating cash flow less capital expenditures) is important to monitor since it cannot be as easily manipulated or massaged as net income, revenues or earnings per share (EPS). Tracking a company’s progress on free cash flow helps decipher the sustainahility and quality of potential future worth.

Management teams need to keep their cost structure in check and not let it spiral upward ahead of sales growth potential or downturns. Properly managing their working capital (things like inventories, receivables or their payables owed to suppliers) is essential. Free cash flow coupled with low current “Net Debt” status (total debt minus cash on hand) represent flexibility to pursue investment opportunities beyond budgeted investment plans. Management teams conscious of not outspending their cash inflows tend to he better stewards of capital allocation. They avoid the temptation traps of investing in non-value-adding projects or ambitious acquisitions.

CAPITAL ALLOCATION
Flow a company allocates its capital is L)robably the most important component of all. One can better grasp how devoted the management is to their business by how they evaluate their opportunity set and if there are hurdles or benchmarks in place. Possibly half the small and mid—sized Companies encountered do not even have strict criteria in place for how to invest! It is important to avoid firms which operate by the seat of their pants or by hunches.” To be a long-term success, there needs to be financial criteria in place for their investments. Publishing a discipline is not enough. Sticking to guidelines without making frequent exccj)tions prevents inefficient use of shareholder capital.

A common pitfall is a managemetu team focused on “Empire Building” through large acquisitions or random geographic expansion simply to grow their footprint. One of the quickest ways for a company to derail itself (and us as shareholders) is to make a large acquisilion of a less familiar entity, lose the prior management team in place at that target, assume massive revenue and cost synergies into their “offer price,” issue heavy debt at high interest rates and then only realize six months later what they truly bought! This becomes even more disastrous after economic downturns, as in 2008, when demand slows and you cannot get reasonable loan terms. More often than not, it is wiser for management to do share huyhacks or increase dividends than to make large acquisitions.

One can avoid capital destroyers by studying the track record of management teams, namely their returns (return on equity, return on capital or investment, return on assets, total shareholder return with dividends and buyhacks). Impressive management teams constantly evaluaie and benchmark their business units. They also divest underperforming margin-drag businesses with anemic sales growth so they can better reinvest behind:

Logical operational shift
New product or service launch
An improving strategic situation

Consistency or upward trend in returns is an important lead indicator. A firm must be capable of returning cash profit on shareholder’s equity.

TRANSPARENCY INTO ACTIVITTES AND INCENTIVES
The more attractive companies disclose details about their subsidiaries and do not consolidate them into opaque reporting. It is better to find companies sharing iheir geographic and business division revenues and profits. [his improves predictability and corn prehension of their drivers. Properly i nceniivized management teams are also more compelling, such as ones with salaries below the industry average, but potential compensation (bonus and stock vesting awards) tied to proper capital allocation hurdles, improving margins or total shareholder return above their peers over a multi-year period. lnceniives should he aligned with shareholders and no based on things easy to financially engineer through debt or stock issuance and short-term cost cutting at the expense oi longer-term growth.

Lastly, it is encouraging to see management teams or board members with their “own skin in the game” by owning a sizeable percentage of shares.

RED FlAGS AND WARNING SIGNS

Companies dependent on too mitch of growth From acquisitions. “Serial Acquirers” are often ticking time-bombs with the exception of a few industries that can truly benefit From small tack-on acquisitions. Only 23% of Sales synergies budgeted by management in their acquisition are ever achieved! Only 60% of Cost synergies are ever realized — so large acquisitions frequently tend he regretful decisions!
Overly promotional management teams. Many CEOs and CFOs like to share their story, but some take it too far by providing investors only a “Bullish” outlook, when in reality they should he toning down expectations to a “Most Realistic” otttlook and not setting themselves up for disappointment later.
When a high level CEO, CFO, or COO suddenly leaves a firm for unconvincing reasons, there should be concern and a quick investigation to
decipher underlying true reasoning for a departure.
Any unwelcome accounting changes, irregularities or aggressive accounting.
Companies or industries mainly reliant on pricing power to generate a decent operating margin (autos, airlines, pulp/paper, commodities, textiles). They suffer during inflationary periods. New competitors might lower prices to capture market share and drive out these incumbents. A customer might switch to substitutes or overseas competitors if prices are too high.
Start-ups or concept stocks not producing cash earnings and instead in early phase consumption capital. Many hiotech companies fall in this camp.
Companies that cannot grow without needing substantial capital raising (debt or equity issuance). Firms that constantly issue Equity Shares to fund their acquisition or growth appetite. This dilutes current investors and is only worthwhile for very accretive projects or investments. The more compelling companies can “self-fund” expansion or growth through their internal cash flow.
Companies too big to grow. Mega-Cap firms like Wal-mart, Dell, Cisco, Microsoft, General Electric, IBM, etc., simply become too large for their sales or earnings growth to outpace the overall stock market. After post- recession recovery is done, they then become reliant on acquisitions or lag.
Management teams selling an abnormally high percent of their holdings. They could he jumping ship before published results show a rapid deterioration in the industry or within their own company.
Sporadic and unprofitable geographic entrances and exits into new countries with limited or no experience there. These are costly management distractions.

NAVIGATING THE CHOPPY WATERS BOILS DOWN TO PATTERN RECOGNITION AND FRAMEWORK
I ligh quality firms are not always apparent and need extra digging. Their common denominator is management with strong consistent track records, good capital allocation, leading niches or market shares, some enduring competitive advantage and not overly burdened with debt. It is essential to pursue companies with some control over their fate, that are not at the mercy of commodities or macroeconomics.

By employing “Pattern Recognition” and a consistent “Framework,” one can better focus time and resources on funneling down their stock universe into a manageable subset of attractive candidates. Over time, an experienced stockpicker will recognize similar traits, themes or commonalities surfacing in less known companies. By honing in on these patterns that occurred in other companies (which might he too large now) or in other geographies (a similar story emerged in the US a few years ago and is now only beginning in Europe), one can more effectively analyze a new candidate and catch it earlier on before too much upside is already given away. As with most stocks, a company without earnings or improving book value will be more difficult to justify as an investment. One needs an “antenna” to identify a pattern of ideal qualities like earnings growth or acceleration in sustainable earnings before other investors realize it and buy the stock.

GOOD COMPANY, BUT A BAD STOCK?
Could you have a good company hut a had stock? Of course. Valuation would be the main cause of this disconnect. The company could be trading at too high an absolute or relative valuation (its valuation multiple versus the peer group average). Plus, investors or sell-side analysts could eventually have too lofty expectations for earnings or sales growth. These too glamorous or emotionally- attached (“Fallen in love”) stocks have little to no room for error. Any disappointment that appears fundamentally driven usually triggers a large stock price drop. This type of high momentum stock could have its valuation multiple quickly compress by a third in a single week.

So, good companies do not always translate to good stocks. There will always be overvalued and stretched stocks, which are more prone to correct or collapse in their stock price. Catalysts could include large customer concentration or single product dependency that could he problematic to earnings if one customer does not renew or if there is a defect recall on a product comprising much of its profit.

Do the company’s future opportunities outweigh its threats?
What are investors’ current expectations of future results (revenues and profit)?
Are there events or catalysts to narrow the gap between the current market price of the stock and intrinsic value within a reasonable time period?
What is the probability of those catalysts occurring?
How sustainable’ and likely is free cash flow generation?

Obscure and ignored companies do not translate to bad stocks. In fact, these can become some of the best stocks. Conversely, very loved stocks with 75%+ “Buy” ratings by sell-side analysts and held by nearly all the largest institutional managers can quickly turn into the worst stocks!

Boring companies do not mean boring, bad stocks. Berkshire I lathaway’s purchase of Burlington Northern Railroad might have seemed dull at the time, but is likely to prove to be one of the best acquisitions by Berkshire in a decade. Most companies have some shortcomings, hut the more compelling ones continually exceed expectations.

Simply because a stock goes up or down by 5—10% in one day does not mean that it is a good stock or a bad stock. What matters is its future prospects and what has fundamentally changed for the company. its outlook, the industry or the economy.

KEY TAKEAWAYS

In order to outpeiform the stock market, one needs to find great mono geinen t teams, unique business models and i niproving or unclerappreciated prospects and wihot stretched stock valuations for their potential. I loning in on superior long—term growl Ii potential, emerging secular growth trends for stronger positioning (niche, market share or pricing power) and profitable capital redeployment are essential to separating good companies from distracting or lackluster ones.
While there is no single “magic formula” for a good or great company, there is a common set of characteristics cincl traits. Furthermore, one cannot easily define an “average” or Thormal” year in the stock market. Some might call it a year in line with the historical long-term average total return (including dividends) of 9.5-L0.5%. But even 9-11% for the S&P 500 has happened only TWICE in the past 40 years. By employing the above framework and a consistent approach to selecting companies, an active portfolio manager should he able to demonstrate outperformance over a longer-term period.
Lastly, most investors overreact to bad news (i.e., sales and earnings misses during quarterly results season). Conversely, this same type of investor unclerreacts to lavorable news or earnings results that exceed expectations. These two types of reactions allow a prepared investor to more effectively prevail.

Our focus is on investing in a stock before others fully realize its powerful prospects, then selling the stock before it becomes too overvalued or fundamentally weakened. Investment management is less about swinging for the fence for only homeruns and more about avoiding the landmines. If you can sidestep two to three pitfall stocks each year (ones that could drop 20-70% in a non-recessionary environment), then you can win by !! losing. The market will stall or correct occasionally, but disciplined investors can leverage that “On Sale” opportunity in their favor by increasing their allocation to higher quality companies demonstrating the aforementioned characteristics.

Any advice or suggestions are provided for informational purposes only and is not a solicitation to purchase any investments or services described herein. Please consult your advisor to determine if an investment strategy is appropriate for you. Past performance of either the domestic or international markets or any specific investments is not predictive of future results nor will diversification alone protect front loss.