Quality at the right price

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

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.