Five Ways to Find High Quality Businesses

Posted on 17. Oct, 2010 by TheFreeInvestor in Investing Philosophy

Before I start talking about specific companies or industries of interest, I want to write about my investment approach and the characteristics that I look for in my investments. Hopefully some of the characteristics will resonate with your investment criteria. First in that list is the quality of the business. I am not looking for a quick speculative trade where I can make some profit in next few days or months. Most of the time, I am looking for investments that I can hold for years, may be decades. So, as a long term investor, it is critical for me that I own business that have the potential of long term greatness. Here are five ways that I use to identify high quality businesses.

1. Technology enabled disruptive businesses

I love businesses that use new technology to disrupt the business models of existing players in the industry. Netflix (NFLX) is a great example of technology enabled disruptive businesses. With a simple no-late-fee, no-hassle, DVD-by-mail business model, Netflix was able to handily beat existing industry leaders, e.g.,  now bankrupt Blockbuster (BLOAQ). Finding these disruptive business early in their life and investing in a portfolio of such companies has worked out well for me. As online businesses continues to mature and evolve, it is exciting and profitable to invest in these trouble makers.

2. Gems in out of favor sectors

The fascination of Mr.Market sifts from sector to sector. As you might have noticed during the weeks following BP gulf oil spill, a lot of  oil and gas drilling company stocks were down – some of that was legitimate risk and many others were excessive fear in the market. In that kind of fearful environment, I look for gems in those out of favor sectors and take advantage of the opportunity to pick up stocks of quality companies at a cheap fire sale price. However, we have to be a bit careful here and make sure that we don’t pick the best run company in a “buggy-whip” industry. In other words, if the entire industry is becoming obsolete then we are better off looking somewhere else for our investments. During the gulf oil spill period, the market presented many such opportunities, e.g., National Oilwell Varco (NOV). You could have picked up this high quality company in the oil and gas drilling industry for as low as $33 around end of June. Now that the crisis has subsided from public attention, the stock is up more than 40% since end of June.

3. Companies with sustainable competitive advantages

I guess, this criteria doesn’t require much explanation. I love companies with a sustainable competitive advantage or, as Warren Buffet puts it – companies that have a formidable moat around their businesses. These companies can maintain their pricing power, and profitability, for a longer time. However, it is not easy to find a business with perfect sustainable competitive advantage. It is a subjective measure and it changes with changes in the market place. New technologies replace old technologies and competitive advantage of the old guard gets decimated. Even though measuring sustainable competitive advantage is not easy, I find it helpful to use this criteria in evaluating quality of a business at a point of time and few years forward. Amazon.com (AMZN) is  a great example of a company with a sustainable competitive advantage among online retail stores. At this point in time, it will be difficult for any other online retailer to beat the scale they already have and continuing to expand.

4. Companies with high growth potential

A lot of value investors are skeptical of high growth companies. Not me. Profitable growth can be a good indicator of quality of a company. Early stage high growth companies often present us with a great  opportunity to ride the growth wave along with the company. The stock of these companies tend to be volatile. But, I am not investing for a quarter or an year. So, as a long term investor, volatility doesn’t scare me out of high growth potential stocks. On the contrary, the wild ups and downs gives me an opportunity to buy these companies at a cheap price. Ctrip.com (CTRP) is one of the fast growing online travel reservation companies, similar to Orbitz and Expedia, in China. It is a high growth company and the stock has climbed up from $7 to $49 in last five years. But, as I mentioned before, these stocks tend to be volatile. In 2008, from a high of $33, it went down to sub $10 levels. So, if you can tighten your seatbelt, high growth potential companies are a good set to look for high quality long term investments.

5. Companies with favorable industry or policy trends

This criteria is the other side of the point #2 I mentioned above. I like to invest in high quality companies that are riding a specific industry or policy trend. It’s an opportunistic approach to find high quality companies. Quality Systems (QSII) is one such company riding the trend of doctors and dentists office computerization. The stock has almost doubled in last five years. Similarly, if you look back to last decade, you can find many companies in the software outsourcing industry that have grown multi-fold riding on the outsourcing wave. As demographics and industries evolve and policies change, we can invest profitably in high quality companies in those industries. The positive impetus of the trend can be helpful in reducing the risk of the investment.

It is difficult to find a perfect stock that is an unequivocal high quality business. Almost always, there is going to be some open questions. However, keeping these five criteria in mind helps me focus my attention better on finding high quality business and invest in them.

Disclosure: As of the publication of this post, I hold long position in NFLX, BP, NOV, AMZN, CTRP and QSII. Please read the disclaimer at the bottom of this site.

Tags: AMZN, BP, CTRP, NFLX, NOV, Philosophy, QSII