MI367: How to Invest in the Best of the Best: Quality Investing w/ Shawn O'Malley

24:43Selling because of a single bad earnings report is too often a knee-jerk reaction that ignores the rate of return a company can earn over time. There is some flexibility on price though with great companies. Quote, if you paid 20 times earnings for a business that was compounding the economic value per share in the mid-teens and have some level of confidence, it is likely to do that for a reasonably long level of time, you'll get to heaven doing that. So that's the three-legged stool approach to quality investing. For more on quality investing, I actually want to turn to someone who's not exactly well-known as a stock investor, but still has a lot to say on the topic.

25:20That is Jim Collins, author of Good to Great and Built to Last, among the best business books ever written from a man who has spent much of his life working with a small team to study the patterns that define successful businesses. What I like about Colin's research and writing is that it fills in a lot of the qualitative blanks that come to mind when discussing quality investing. It's easy to say that you should find great companies to own, but what does that actually look like? There's a lot more nuance than just repeating cliches about wanting to invest in companies with strong moats or great business models or management that is aligned with shareholders.

25:53Colin's book really helps to paint the scene for what makes quality companies stand out. To identify the timeless fundamentals that define quality companies, Jim Collins and his partner Jerry Porras in the 1990s embarked upon an intensive six-year research project that led to the book Built to Last. They studied the founding, growth, and development of exceptional companies that have stood the test of time, companies like Hewlett-Packard, 3M, Motorola, Procter & Gamble, Merck, Nordstrom, Sony, Disney, Marriott, and Walmart. I'll mention that some of these companies may seem a bit less exceptional now than they might have in 1995.

26:29So try and think about the context of the time as we go through Collins' takeaways. But the point remains that even 30 years later, they're all still household names with billions of dollars in market capitalization. These visionary companies, as Collins refers to them, had both endurance with an average age of nearly 100 years and a sustained performance. For example, at the time of the study, their stock had performed 15 times better than the overall stock market since 1926. They also studied each visionary company in contrast with a comparison company that had roughly the same opportunities but didn't turn out as well.

27:05Procter & Gamble's, for example, was Colgate-Palmolive. While Collins calls these firms visionary companies, you could just as easily call them compounders. One of the more lasting insights from Collins' research is his finding that companies should be more like clock builders, not time tellers. The way he explains the difference is by asking readers to imagine a remarkable person who could look at the sun or the stars and quickly know the exact time and date. The only thing more amazing than that would be building a clock that could tell the time in the same way long after they were dead or gone.

27:36The point being that having a single great idea or charismatic leader is akin to time telling, whereas building a company that can prosper beyond the tenure of any single leader or product life cycle is clock building. The company itself is the ultimate product for clock builders. Achieving that requires seeing products and market opportunities as vehicles for building a great company, not the other way around. In fact, only three of the 18 visionary companies Colin studied began life with a quote-unquote great idea. For 17 of the 18 pairs of companies in the study, the compounders were guided more by a core ideology, a purpose beyond just making money, than the comparison companies.

28:15He uses the word ideology because as he puts it, quote, we found an almost religious fervor in the visionary companies as they grew up that we didn't see to the same degree in comparison companies. On top of that, his study of enduringly successful companies found that many had cult-like cultures around their core ideologies, making them passionate about being the best in the world in some niche. Walt Disney, for example, created an entire language devoted to this, where workers weren't just employees, but they were cast members and customers were guests, while jobs were parts in the performance.

28:49If Disney feels like an outlier, consider that Collins found this to be true at a range of companies, including small ones. At the rock and asphalt business Granite Rock, employees were called Granite Rock people, and not just anyone could be a Granite Rock person. Granite Rock people uniformly had a deeply embedded care for quality, service, and fairness. And if that didn't resonate for you, there was no place for you at Granite Rock. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you.

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32:31That's theinvestorspodcast.com slash tip-finance. All right, back to the show. Another insight I found interesting from Collins is the emphasis on homegrown management among quality companies built to last. Through the 1 ,700 years of combined corporate history that Collins combed over, there were only four cases among the enduringly successful companies they studied where they hired an outside chief executive, whereas the comparison companies in the study were six times more likely to go outside for a CEO. As Collins puts it, our findings simply do not support the widely held belief that companies should hire outsiders to stimulate change in progress.

33:09The reason that Collins thinks this matters is that insiders preserve the organization's core values, understanding them in their gut to a degree that outsiders typically cannot. At Motorola, for example, Bob Galvin spent years learning from his father, Paul Galvin, founder of Motorola, before becoming CEO. Bob Galvin then kept Motorola's core ideology intact and simultaneously revolutionized the company. At the very moment he began that revolution, by moving the company out of television sets and into solid-state electronics, integrated circuits, and cellular communications, Bob Galvin also began succession planning for the next generation of leadership, a full quarter of a century before he would pass the reins, to maintain a lineage of homegrown leaders to preserve Motorola's core values.

33:55At great companies that Collins studied, like Sony, Walmart, Disney, Johnson & Johnson, Marriott, and Ford, among others, the founding entrepreneurs served as CEOs for an average of 37 years, dispelling the notion that early founders aren't equipped to manage companies as they scale. Even more interesting is that these successful founders, in the spirit of homegrown leadership, were succeeded by insiders who oversell the company for 24 years on average after them. That is an average of over 60 years of continuous leadership from just two different people among some of history's best examples of quality companies.

34:31The quality companies that Colin studied also rallied around what he calls big, hairy, audacious goals, or BHAGs for short, which had driven the companies to continuously improve. In 1945, Walmart founder Sam Walton's BHAG was to turn his single store into the best, most profitable retailer in Arkansas within five years. As Walmart grew, new BHAGs would replace the old. A second way to stimulate the drive for progress is to create an environment that encourages people to experiment and learn, to try a lot of stuff and keep what works. 3M began life as a failed mine and could not pay its first president a salary for 11 years, yet it grew into one of the most innovative companies in history, eventually branching into more than 60 ,000 new products.

35:18As Collins puts it, at any great compounder, continuous improvement is a way of life, not a management fad. The challenge is to build for the long term while doing well today. The balance then among great clock building compounders is to both preserve the company's core and stimulate progress. They need a continuity of values while an open mind to change, whether that be in changing internal processes or experimenting with new products. Collins adds, quote, the truly great companies of the 21st century will change within the context of their core ideologies while also adhering to a few timeless fundamentals.

35:55Collins has a lot more to say about what enables companies to stand the test of time and continue compounding successfully or return to greatness after periods of mediocrity, but that covers what I wanted to focus on for now. The built to last study doesn't perfectly overlap with say Chuck Ackray's definition of quality. But as I've said, there are a range of perspectives on what quality businesses look like. And I think Collins's insights add another dimension to the conversation on quality investing. For yet another perspective on quality investing, I want to turn to Chris Mayer, who runs Woodlock House Family Capital and is the author of the book 100 Baggers.

36:33Mayer is a wealth of wisdom on quality investing in compounders, and he's built a career around identifying them. Mayer's book is excellent, as is his blog. I want to highlight a few of his many wonderful insights on standout companies that compound returns for shareholders for decades. In a March 2023 blog post, he discusses the concept of linearity with respect to compounders. That is, the best compounders have linear stock charts. If you zoom out on the company's stock price over time, it goes up and to the right in a relatively straight line. That's because they're consistently profitable, reinvest their profits, and are not overly impacted by economic downturns.

37:11One such illustration of this is the 10-year chart for one of Mayer's portfolio companies, Constellation Software, which has a remarkably smooth upward sloping stock chart with a nearly 1 ,900 % return over the past decade. That's 34.9 % compounded annual growth. Meanwhile, if you did the same thing with a more cyclical business like United States Steel Corporation, its 10-year stock chart has four distinct peaks, two major troughs, and a handful of smaller ups and downs. After all the ups and downs, it has just a 2.8 % compounded annual growth rate, meaning its growth is essentially only keeping up with inflation.

37:48That is not a good compounder. So Mayer talks about trying to reverse engineer the linearity of compounders like Constellation and one of the key components, which Mayer learned about from reading the book The Intelligent Quality Investor, is that compounders tend to convert a high percentage of their earnings into free cash flow per share. Free cash flow, if you're not familiar with it, measures profitability by excluding non-cash accounting expenses like depreciation and adjusting for working capital needs as well as capital expenditures. After those adjustments, free cash flows represent the amount of profits actually available to lenders and shareholders.

38:23Companies that do not convert as much earnings into free cash flow warrant skepticism because it can indicate that the company's earnings are low quality. One simple example is to imagine a company that makes most of its sales on credit to customers who really cannot afford to pay them. For a time, sales and accounting earnings might look strong as these customers make purchases on credit, but if these sales made on credit never actually go through, you would see that reflected in lower free cash flows. The observation that Mayer is making is that compounders tend to convert larger amounts of net income into free cash flows by doing things like more efficiently managing their inventory, collecting cash sooner for sales generated on credit, and making optimal use of tax credits and deductions, among really a full list of similar things that could possibly be done to boost the cash flows coming in over profits on paper.

39:12Mayer makes another nuanced point about compounders and corporate culture. Investors often talk about corporate culture, but what does that mean and what makes for a good corporate culture. To him, culture includes how a business deals with employees, customers, and suppliers, as well as how it compensates and incentivizes executives. Sometimes, as Mayer points out, you can find revealing clues about a company's culture in its annual financial reports, also known as 10Ks. In one such report for a compounder he owns, Brown & Brown, they write in their 10K that over 20 % of the company is owned by employees and that 60 % of employees own at least one share in the company.

39:51That is the definition of an ownership culture. As an outside shareholder, you could find comfort in knowing that more than half of the company's employees are shareholders alongside you. They benefit in the same proportion as you do to advances in the stock. Mare cites this as one of the many possible indications of a good culture that's compatible with compounders. Additionally, good cultures tend to have lower employee turnover. One of Mayer's other portfolio holdings, Old Dominion Freight Lines, invest heavily in training programs that boost employee retention, and has well below average turnover for the trucking industry.

40:25As you dig in and research companies to try and better understand their culture, management, and industry positioning, you can find lots of great hints like these that will help you read between the lines in assessing whether a company is likely to compound its returns at above average rates for years going forward. Whether you're filtering out companies based on having an inadequate track record of generating returns for shareholders, for not having much pricing power or lasting moats to protect competitive advantages, for not being family or employee owned, having too much debt, or for not having a good culture, you'll quickly realize that the investable universe of companies before you shrinks down dramatically.

41:01There's just not as many companies that meet the full checklist of quality as you'd think. Chris Maris says that over time, he's become even pickier as an investor, and his checklist has grown longer and longer. In his blog, Mayer writes, quote, I have a hard time finding 10 names I love. I exaggerate, but not much. I have 10 stocks in my portfolio now, and I'd be hard pressed to name 10 more that I'd love to own at the right price. Pickiness is okay, though. As a long-term investor, you may need only a few great investments across a lifetime. Warren Buffett is known for saying, quote, I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches, representing all the investments that you could make in a lifetime.

41:46In Buffett's case, a few investments really do stand out, like Coca-Cola. By 1994, Buffett had paid$1.3 billion for a stake in Coke that's now worth$25 billion and pays Berkshire over$700 million a year in dividends. As Buffett put it in his 2023 shareholder letter, talking about winners and mistakes, he says, the weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders. In another blog post called The Best Businesses to Own, Mayer reflects on how people often tell him that a stock is quote-unquote expensive because it trades at some high multiple of earnings or cash flow, and his response is usually to ask, well, what is your time horizon?

42:30The point being that saying a stock is expensive today based on a multiple of its current earnings is far less informative than it would sound. If a company's profits are set to triple over the next three years, and you are choosing not to invest based only on its valuation as a multiple of profits from the last 12 months, then you'd be using the wrong frame of reference. In this instance, the stock's valuation looks expensive today relative to recent earnings because investors are piling in ahead of expectations that it will triple its profits in three years. From a quality investor's perspective, it then becomes more of a question of how confident you feel that this future earnings growth will occur and whether you think investors are over or underpaying for that growth.

43:11If this sounds familiar at all, it's because there are always lots of examples of this in markets, but the easiest comparison to make today is probably with NVIDIA. At any point in the last year, NVIDIA's valuations based on recent earnings have looked crazy. And you may still think it's crazy based on projections of future earnings, but the company's future prospects have grown hugely as excitement around AI has built up since the company is by far the dominant player in the market for designing computer chips that power AI systems. So when it comes to valuing NVIDIA, time horizon matters hugely, and the same is true for any quality company you're evaluating.

43:46Mera provides an additional way to think about time horizons and investing with a simple graphic. The graphic goes from left to right, showing the timeline progressing from quarter to quarter to 10 plus years with the factors primarily driving investment results over those periods layered over. Over one quarter, what drives investment results the most is usually sentiment. Sticking with NVIDIA, as people get more bullish on AI, that's probably going to drive NVIDIA's price up over the following months. And if the outlook for AI adoption shifts, that sentiment is going to hurt NVIDIA's stock. Changes in valuation multiples tend to drive investment results on a year-long time horizon.

44:24For example, a company may go from trading at 15 times next year's estimated earnings to 12 times. Over two to five years, the broader economic cycle and industry trends will typically be what shapes the company's returns. And then on a five to 10 year basis, returns are driven by the company's returns on invested capital. After 10 years, people and culture are what fundamentally determine returns, as we talked about with Jim Collins and companies that are built to last. Meir's takeaway is to focus primarily on the right side of the chart, specifically companies' ability to reinvest to generate high future returns in capital, as well as focusing on people and corporate culture.

45:00He says that he spends most of his time, quote, understanding the people and the culture, getting a handle on incentives, and trying to figure out the reinvestment opportunities and the returns the company is likely to make on them. I spend almost no time thinking about things like sentiment change or building a thesis around a change in multiple. Over a decade of ownership, those things don't matter much. He adds, quote, price is important, but these items on the right are more important. If I don't have those, I'm not interested even if the stock looks cheap. Besides, the importance of the price you paid is another thing that bleeds out over time.

45:33Unless you really overpay big time, if you are right on the quality, you're going to do okay. If a stock is going to do 20x for you, then 30 % more on the purchase price is not going to kill you. Even if you overpay, you can still do well if you size it right and give yourself room to buy more later. But you got to be right about the business. And that's why the bulk of my focus and research is on the right side of that chart. In his quest to find compounders who can generate 100X returns, Mayer has landed on a framework he calls the twin engines of growth. In short, the twin engines are underlying earnings growth and a higher multiple on those earnings in the valuation.

46:10In other words, you hope that not only will your quality stock compound returns, sales growth, and free cash flow, or whatever the key metric is for that business at double digit rates, but also that the multiple of sales or earnings that the stock trades at goes up at the same time, further juicing returns. If a company compounds returns at 20 % per year, it will deliver 100X return in 25 years, assuming the stock's price to earnings ratio remains the same. But if its valuation multiple rises from 15 times earnings to 30 times earnings by the end of that 25 years, as investors are willing to pay a premium for such a high-quality company, then your full return goes from 100 times your original investment to roughly 200 times.

46:50As great compounder stock prices thrust off into the atmosphere, rising valuation multiples accelerate the journey to eye-popping returns. Let's look at NVIDIA. In 2013, NVIDIA traded at 14 times earnings. In 2021, it traded at an average valuation of 110 times earnings. Meanwhile, NVIDIA's compounded annual growth rate for sales has been about 34 % over the past decade, according to Finchat. Incredible rates of sales and earnings compounding, which is Engine 1, paired with a huge rise in its earnings multiple, aka Engine 2, from 14 in 2013 to over 100 in 2021 and around 70 today, the stock has delivered a more than 300 times return in the last 10 years.

47:35The compounding of returns and higher multiple have worked together to deliver what is truly an incredible return for NVIDIA shareholders. While quality companies can deliver excellent returns without the help of the second engine and rising multiples, it certainly helps to have that tailwind in your favor. And the wonderful thing about great compounders is that rising multiples tend to work in your favor, or at least tend not to significantly work against you in the long term. That's because with truly quality businesses, you will not be the only one to recognize it usually, and people will pay up to own a company as they realize just how good it is.

48:09So as always, we've covered a lot today, from the building blocks and patterns of quality companies, to the importance of pricing power, corporate culture, management with skin in the game, and reinvestment. We went through Peter Slagers, Lawrence Cunningham's, Chuck Ockray's, Jim Collins, and Chris Mayer's different but similar frameworks for understanding and identifying the best of the best companies and markets over the long run. The biggest challenge with quality investing, I think, is to ensure that you're not just selecting for companies that were the best of the best yesterday, but for those who will continue to be so tomorrow.

48:42That's where the real art and skill is. Anyone can go on a stock screener and filter for above average rates of sales or earnings growth with modest amounts of debt and call that quality. But you'll blindly be picking companies that have been the best quality, not necessarily those that are positioned to continue being the best quality. Looking at things like whether a company has more pricing power than its peers, whether customers go out of their way to recommend a company's products, whether the company has a good corporate culture, as Chris Mayer would say, and whether it encourages its employees to buy its stock and be owners, whether it has a culture of breeding homegrown leadership, whether they have the sort of religious fervor for their mission that Jim Collins describes, that can all give you qualitative insights that build on the quantitative screens you might run to identify sets of potential quality companies to own.

49:29I had a lot of fun diving into the art of quality investing, in part because it resonates with me more than any other approach to investing that I've personally studied. It just makes a ton of sense to focus on the factors that determine outcomes for businesses the most, and then look for companies with the best track records of success that are likely to continue that momentum going forward. I'll leave you with the following on quality investing. The Nobel Prize-winning economist Paul Samuelson tells us, quote, investing should be more like watching paint dry or watching grass grow. If you want excitement, take$800 and go to Las Vegas.

50:03That's all for today, folks. And thanks for watching. I hope to see you again next week.

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