Case Study: Identifying good quality businesses
This is Part 6 of A Portfolio For Mom, which explores the portfolio we're building for one of our most important clients. The series outlines our investment philosophy, centered on loss avoidance, while hopefully educating our client through a variety of case studies.
We'll introduce the philosophy, present case studies, and discuss potential stock candidates. With the help of the Seeking Alpha community, we hope to improve her investment returns.
In this edition we'll introduce a simple relatable framework to help Mom understand why we're selecting certain businesses for her and avoiding others. We hope this Case Study will help her further "buy-in" to our philosophy.
A Good Quality Business
A quality business is run similarly to how an individual or family should run his or her personal finances.
As a family we want a few things:
- Salary stability: it sure is easier to plan and save when our salary is stable and reliable year after year
- Net savers: we also want to spend less than we what earn (each and every year)
- What we do save, we want to spend it on worthwhile things and get a lot of value for our money
- Income growth: it'd be great if income grows faster than our expenses
- Low debt: we also want to use debt as an option, not a requirement to live day-to-day
When looking for a company, we want similar things:
- Revenue is relatively stable (and doesn't decline much in recessions).
- Companies that have a track record of positive earnings over many years (i.e. net savers)
- We want companies to spend money on initiatives that payback quickly (they get good value for their money)
- Income growth year after year
- Low debt: a quality company shouldn't have too much debt either
In your portfolio you'll find these companies often have competitive advantages - a feature of the business that makes them superior to another company.
Sometime size is that advantage. Sometimes it is a brand name. And sometimes it is a unique talent or capability that enables them to run the business better than peers. Think of a family. Often, it's not how much you make, it's how much you save. For a company, a similar idea applies: it's not how big you are, it's how much profit you earn.
Let's consider Metro (OTCPK:MTRAF). Grocery stores are one of the most stable and boring businesses out there. Again we think the stability of grocery retailing gives us a head start when trying to avoid losses. We think Metro runs its business like a really smart family and is operationally superior to many others. They consistently spend less than they earn, they grow income modestly, and have always kept debt low. Plus they have a lot of really great locations.
Like a family with well-run finances, Metro is ready to handle any surprises.
Bigger is not Always Better
As mentioned we like grocery stores because they operating in boring, stable industries. We all have to eat and grocery prices don't rise or fall dramatically like some commodity prices. This gives a good head-start when trying to avoid losses.
However, this doesn't mean all grocery stores are great investments. Just because someone makes a lot of money doesn't mean they will manage their finances well. A rich, flamboyant celebrity can experience financial difficulty just as easily as you or I.
A few years ago you might remember that Loblaw's (OTCPK:LBLCF) bought Shoppers Drug Mark and fellow grocer Empire Company, owner of Sobey's, bought a large Western Canadian chain called Safeway. Both grocers used a significant amount of debt to purchase those assets. Canada's third grocer, Metro, did nothing.
Fortunately for Loblaw shareholders, they've paid the debt back very quickly and have done reasonably well. Empire, on the other hand, struggled with the new business and the slowdown in the Alberta economy only exacerbated the problems. At Empire, bigger has definitely not been better.
And what about Metro? Metro still has a very healthy balance sheet. As a result, management has not needed to spend much time worrying about debt repayment and instead focused on operating the business, which they ran far better than Empire or Loblaw. The share price of Canada's smallest grocer has far outpaced its larger competitors.
Sometimes it's all about the little things day-to-day that make a difference
Up next is Part 7, which will continue selecting stocks for A Portfolio For Mom. The theme of the next five companies is "really great dividend yields". We think they have the brands, profitability and balance sheets to protect capital and generate good returns for Mom.
We feel this is one of the tougher concepts to relate to novice investors - do you think it's relatable? How do you help others understand your investing concepts?
Disclosure: I am/we are long MTRAF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.