Keith Ashworth-Lord and the Buffett way: Part 2 – Quality Investing
Keith Ashworth-Lord is a quality investor through and through. Quality investors like to do their homework and figure out whether a company is adding value. The obvious question to ask is: how can we define a high quality business?
Keith lists a number of attributes he looks for in a quality business in his book Invest in the Best. They can be broken down into the raw numbers and a qualitative (touchy, feely) assessment.
Defining quality: the numbers
A key metric that Keith looks for is a high return on equity (ROE). Terry Smith, by contrast, focuses on the return on capital employed (ROCE) that a business generates.
I am with Terry on this one and start with ROCE before moving onto ROE (sorry Keith). ROCE tells you how good a company is at generating a return on all the capital it employs.
Another requirement for Keith is that a high proportion of accounting earnings convert into free cash flow i.e. show me the cash. This criterion should result in a bias to invest in capital light businesses.
Keith also prefers organic growth rather than “frenetic acquisition activity.” Finally, there is a preference for the financial accounts to be “transparent.”
Defining quality: touchy, feely stuff
Moving onto the touchy feely stuff and Keith looks for an “easily comprehensible business model.” The operational performance is also required to be consistent and result in “relatively predictable earnings.”
In my view, the most important criteria that Keith looks for in a quality company is an “enduring franchise with pricing power born of superior competitive advantage.” Without this safeguard the future performance of any business will be in doubt.
Last but not least, no one wants a bunch of jokers running the show. Keith therefore looks for “management that acts with the owner’s eye and is focused on delivering shareholder value.”
Profitability of capital: bad, good and great businesses
Keith breaks up businesses into three types: bad, good and great. This is a very helpful categorisation as other quality investors only appear to label businesses as either good or bad. (The three labels remind me of the Western: The Good, the Bad and the Ugly!)
Starting with bad businesses, they have to invest “just to stay in the game.” Management are investing capital at a rate of return that is below the cost of capital.
Examples include the steel and the textile industries i.e. the “smokestack” industries. The cash flow generated by these businesses is used to “prop up yesterday’s poor operating performance.”
Turning to good companies and they earn a return on capital that is above their cost of capital. This generates a “perfectly satisfactory” result with examples including Rotork (ROR), Spirax-Sarco (SPX), Victrex (VCT) and A.G.Barr (BAG).
AG Barr: a good but not a great business
Source: AG Barr
AG Barr is only a good business: ROCE at 18%
Moving onto great businesses, return on capital is high and cash flow is described as “copious.” Great businesses have franchises based on intellectual capital and the companies therefore have modest reinvestment requirements.
Great businesses return more and more cash and don’t require you to put much cash in. Examples of great businesses include: RWS Holdings (RWS), Hargreaves Lansdown (HL.), Bioventix (BVXP) and Games Workshop (GAW).
Hargreaves Lansdown keeps customers happy
Source: Hargreaves Lansdown
Hargreaves Lansdown is a great business: ROCE at 80%
Against this backdrop the following quote from Keith shouldn’t be surprising: “It is the interaction of growth and profitability as measured by the return on capital that determines real value creation in a business.” Keith’s focus is on the return on capital rather than popular metrics like earnings per share growth.
Cash is king: if there is one chapter to read!
Turning to chapter six, Keith says:
“If there is one chapter of this book – and only one – that investors should read, understand and commit to memory, this is it.”
Keith’s Northern bent starts to come out in the chapter when he refers to EBITDA as “particularly daft.” He also states that: “investment bankers and analysts talk a lot of rubbish about cash flow.” Why don’t you tell us what you really think?
Keith doesn’t mess around and prefers to focus on free cash flow rather than bottom line profit. In other words, how does the cash available to the owners of the business compare to the net profit that is being reported?
This contrasts to a comparison that is sometimes made between operational cash flow and operating profit. The problem is that depreciation is charged against operating profit, but there isn’t a similar charge against operating cash flow.
Keith therefore describes the comparison between these two financial metrics as irrational. I tend to agree with him.
If you have a choice of investing in bad, good or great businesses then the latter is surely best (at the right price). Great businesses have the potential to deliver truly exceptional long-term returns for investors.