Just to add to my thoughts to the above:
What is a good business? What is a quality business?
Lawrence Cunningham in his book Quality investing defines quality businesses as those which can generate high levels of free cash flow, return higher than cost of capital, is sustainable and can grow its earnings consistently over long periods of time.
In another excellent book, competition demystified, Bruce Greenwald talks about entry barriers. This actually roughly ties in with the sustainability of earnings point.
Michael Mauboussin writes this about good quality businesses:
A high-quality business is one that is profitable, typically as a result of high margins, has relatively low debt, a very capable management team, and a business that is unlikely to change abruptly in the near term. So essentially it is a business with a high return on invested capital and stable prospects.
And this about good management:
All roads in managerial evaluation lead to capital allocation. A high-quality management team is one that knows how to take resources, including capital and people, and put them to their best and highest use. Quality executives are ethical, open-minded, thoughtful, judicious risk-takers, transparent, and long-term oriented.
The challenge is all this is very difficult to figure out in real-time. Most of the time, tailwind or headwind in the business makes a management look far better or worse than they actually are. We, most of the times, have to go with our gut-instinct about the management based on a few interactions or how they speak etc.
Example - When Pidilite management is able to brand a commodity business they are termed after many years of success as visonary. Asian Paints was able to do the same. When Astral was doing it the same thing was being said. Now I hear the same thing for APL Apollo. But no one talks about all those other players who also tried creating brands and failed miserably (not for the want of trying). Nerolac, ICI, Dendrite etc. They remained marginal players in the same industry. Even DHFL used Shah Rukh Khan as their brand ambassador. A world of good it did for them!!
Next question is then how to distinguish between a good and a great business? Or conversely, between a good and mediocre business.
One thing I have firmly seen is a consistently good return on capital (whichever way we measure it - RoE, ROCE or ROIC etc) for a good business. But a good ROCE does not automatically mean that the business or its earnings are sustainable for long periods of time. Or that the business cannot be disrupted materially by external or internal conditions over a short period of time.
Back to Mauboussin. On source of competitive advantage.
The closest thing I’ve seen to an empirical study of this question is the work by Michael Raynor and Mumtaz Ahmed, consultants at Deloitte, that was discussed in their book, The Three Rules . They analyzed thousands of companies going back to the 1960s and suggested that superior performance, results that are above and beyond what luck allows, is the result of companies following two rules. The first rule is “better before cheaper.” In other words, do not compete on price. The second rule is “revenue before cost.” Successful companies focus on increasing sales rather than cutting costs. The title suggests a third rule, which, irritatingly, is that there are no other rules.
Those rules seem closer to a differentiation strategy than a cost leadership strategy.
So, question to ponder is this – is there genuinely a way/model/framework possible that is going to help drill down business quality into its components? Or is it just a chimera we are running after?
I will end this with the following study done by McKinsey on the 50 companies appearing in the 3 seminal books - Good to great, Built to last and In pursuit of excellence.
Performance of the “excellent,” “lasting” and “great” companies vs. the S&P
| "In Search of Excellence" | "Built to Last" | "Good to Great" | |
|---|---|---|---|
| (1982-2002) | (1994-2004) | (2001-2016) | |
| Stars (more than | Wal-Mart | Philip Morris | Phillip Morris |
| 5 percentage points | Intel | Marriott | Nucor |
| better than the market) | Merck | ||
| Johnson & Johnson | |||
| Outperformers (more than | Procter & Gamble | American Express | Kroger |
| 2 percentage points | Avon Products | Johnson & Johnson | Wells Fargo |
| better than the market) | Walt Disney | IBM | |
| DuPont | Wal-Mart | ||
| 3M | Nordstrom | ||
| 3M | |||
| Middle | Dow Chemical | Procter & Gamble | Gillette (a) |
| Bristol-Myers Squibb | Boeing | Kimberly-Clark | |
| Boeing | Walt Disney | Walgreens | |
| Amoco (a) | Merck | Abbott Labs | |
| Emerson Electric | Hewlett Packard | ||
| McDonald’s | General Electric | ||
| Caterpillar | |||
| Texas Instruments | |||
| Underperformers (more | Maytag (s) | Ford | |
| than 2 percentage points | Hewlett-Packard | ||
| worse than the market | IBM | ||
| Delta Air Lines (s) | |||
| Failures (more than 5 pct. | Schlumberger | Citicorp | Pitney Bowes |
| pts. worse than the market) | Kodak (s) | Motorola | Fannie Mae |
| Raychem (a) | Sony | Circuit City (b) | |
| Key | Amdahl (a) | ||
| (a) Acquired during | Dana (s) | ||
| evaluation period | National Semiconductor (a) | ||
| (b) went bust during | DEC (a) | ||
| evaluation period | Data General (a) | ||
| (s) subsequently acquired | Kmart (b) | ||
| or went bust | Wang Labs (b) |
We came to some interesting, even surprising, conclusions.
Great companies were more likely to do really badly than really well.
Their odds of outperforming the stock market were 52-48, hardly better than a coin toss. But there are more big losers than big winners on the lists. Just eight companies outperformed the index by more than 5 percentage points, while twice that number underperformed by the same percentage.