10 factors to judge the quality of a business

From an investing point of view, “high quality” is subjective. Subjective to your risk appetite, time horizon and your own biases. But it would be fair to say that, a company that can assure a certain amount of return over a period of time can be considered as high quality. The quality coming from the certainty to which we can look into the future.

That said, there are countless ways in which the future can unravel. Hence, we need to have a margin of safety in our thesis about a company and it’s future.

The analysis can be divided into a qualitative and quantitative parts.

The 5 main qualitative perspective are

  1. How does the business make money? What is it’s business model? What are the core features of the business that customers are paying continually paying for?
  2. Does it have a competitive advantage? Will that advantage strengthen or weaken as the business expands?
  3. Are they innovating with changing times? This shouldn’t be read as, are they jumping on the hype wagon every couple of years to prop up investor sentiment. Rather, is the business having a good balance of exploring new avenues and maintaining it’s core business.
  4. What are the major risks for the business? Are there any other businesses that can take its place easily?
  5. How are the people running the business? This is hard to judge without having any kind of contact with the management. Have they been on the news lately? And was it for a good or a bad reason?

The 5 main quantitative aspects to figure out are

  1. How has the returns been historically? What drove them over the years?
  2. What are the costs for running the business? Are the costs growing or dropping and why? How will the costs change as the business expands?
  3. How much debt does the company have? Is it good debt or bad debt? Will it be able to payoff most of it’s debt if an adversity occurs?
  4. What are the margins in the business? How much pricing power do they have?
  5. These metrics alone are not that helpful in itself. The key step here is to compare it with that of it’s competitors and against the backdrop of the industry the business is in.

Coffee-Can Investing

Coffee Can investing was first popularized by Robert G. Kirby in an article he published in the fall of 1984.

Coffee Can investing riffs off of an old-fashioned saving method where you physically earmark some money, put it in a coffee can, and basically forget about it. And only consider opening it either after a long time or when you desperately need the money.

Converting that concept into an investing strategy, this is how it would look like.

You would begin by allocating money to a number of high-quality companies and forget them for a period of 10 years. No buying or selling during this period. “Just” hold on to dear life.

Then you might ask, why not invest an index fund and hold that for 10 years. Well, for most people, the index fund is still a very good option. But the upside of how much an index can run in a span of 10 years is capped. This cap is typically due to the fact that the growth and return of an index fund in averaged among all of it’s constituents. Despite a few high performing companies, the index would still move slower.

However, the coffee can strategy does have an elegant logic behind it. Consider that you have $100 Million dollars to invest. If you split that into 50 investments in high quality companies worth $2 Million each. The maximum you could lose in one holding is only 2% of the total portfolio while the upside is uncapped. Chances are that at least a couple of the holdings turn out to be a multi-bagger and provide a net profit at the end of 10 years.

An advantage of this kind of investing is that the amount compounds over time and fetching every dividend along the way. Compounding works well when it is not disturbed.

A detriment to an investment strategy are it’s transaction costs. A great strategy with too many transactions would then begin to eat up the gains anyway. Coffee can investing solves that buy reducing transactions to the absolute minimum.

A downside is that it requires you to invest a lump sum amount up front. In addition to that it does take time and effort to figure out which companies are “high quality”. But it is doable.