Qual­ity at the right price

Com­pa­nies with a strong com­pet­i­tive ad­van­tage should be on an in­vestor’s radar

Money Magazine Australia - - VALUE.ABLE - Roger Mont­gomery is founder and CIO at the Mont­gomery Fund. For his book, Value.Able, see roger­mont­gomery.com.

When it comes to stocks, the term “qual­ity” has many def­i­ni­tions. Some in­vestors adopt a flex­i­ble ap­proach to the def­i­ni­tion, be­ing sat­is­fied if qual­ity man­age­ment is run­ning the busi­ness, a qual­ity cus­tomer base ex­ists or they can iden­tify qual­ity as­sets on the balance sheet. The most prag­matic in­vestors will be sat­is­fied if a com­pany, even in an in­dus­try with poor eco­nom­ics, is good qual­ity rel­a­tive to its peers.

At Mont­gomery we ad­here to a very spe­cific def­i­ni­tion of qual­ity: a com­pany must be able to sus­tain­ably gen­er­ate high rates of re­turn on its in­cre­men­tal eq­uity. We look for a com­pany with a busi­ness that can not only re­tain a large pro­por­tion of its prof­its each year but can also gen­er­ate a very high rate of re­turn again on its now larger amount of eq­uity.

Ob­vi­ously, high re­turns are bound to at­tract com­peti­tors who would nor­mally en­ter the mar­ket of­fer­ing lower prices, cut­ting mar­gins and prof­itabil­ity for all play­ers. So to achieve very high re­turns sus­tain­ably, the busi­ness must pos­sess a com­pet­i­tive ad­van­tage. A com­pet­i­tive ad­van­tage puts a com­pany in a favourable or su­pe­rior busi­ness po­si­tion and the most valu­able com­pet­i­tive ad­van­tage is the abil­ity to raise prices with­out a detri­men­tal im­pact on unit sales vol­ume. There aren’t many com­pa­nies that have this abil­ity. How­ever, there are enough in Aus­tralia to build a port­fo­lio, pro­vided pa­tience is ap­plied to the pur­chase, which must also be at an at­trac­tive price.

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