Quality Compounders Team
Private Client Adviser
We believe that business performance is determined by its corporate culture, this culture must be built it never occurs by accident and is the result of conscious effort by management. We see there being two ends of the cultural spectrum; meritocracy and bureaucracy.
Meritocracy: A meritocracy is not an organizations natural cultural state as you are required to earn the right to contribute to decisions by your past success. Successful contributors accrue more relevance in future decisions.
Bureaucracy: A bureaucratic culture is one that stifles merit-based decision making, decision makers are elevated to a position of contribution by non-merit factors such as tenure, peer acceptance and politics.
Owner managers build business culture around a meritocracy rather than a bureaucracy because they are results orientated, they primarily want the best business performance because it is their own business. A hired hand (non-owner manager) often has divergent objectives such as their professional reputation, meeting short term objectives for personal incentives and risk aversion for employment security.
Our Owner Management checklist among many other points uses the below measures to define an owner manager:
Shares on Issue <5% CAGR over 20yrs, ultimately negative growth.
CEO Stock to Salary ratio >20x, ultimately infinite.
Overtly engaged culture, ultimately winning best place to work awards repeatedly.
Shares on Issue: We believe this is a great indicator of owner management. Business owners don’t like diluting their ownership. Hired Hands don’t mind because they don’t own much stock, in fact some see the event of raising capital as a favorable professional attribute. Maintaining zero to negative share count growth means that the capital allocator in the business is aware of the effect this has on long term value.
Stock to Salary Ratio: The ratio of stock to salary separates the incentive of business and person. We believe that some managers that are not the original ‘founder’ or biggest shareholder can still be an ‘owner manager’ if they are more incentivized by the business success than their personal bonuses.
Overtly engaged culture: Ultimately any business is a combination of people all producing a good or service, if everyone is working against each other inside this business then its hard to expect anything but poor long-term performance. We look for businesses that attract passionate team contributors, engage them and retain them for reasons other than solely remuneration.
The purest expression of competitive dominance is the power/control you have on the sale price of your good or service. This can present itself in different ways, sometimes it shows up as increasing prices and large gross margins (Hermes – Birkin Bag) and sometimes it shows up in decreasing prices and low gross margins (Costco). The common thread though is that the business makes the pricing decision and not external factors such as the season, economy, competition, regulator etc.
The business model that has the ultimate pricing power characteristics is an unregulated monopoly. This means the business is the sole provider or owner of a good or service, in most economies these monopolies are such powerful business models that they attract governments regulation. This results in pricing restrictions or supply being dis-aggregated so that these businesses can’t exploit minorities, the clearest example in history is Standard Oil which commanded 90%-95% of American Oil Refining market share in 1880 and was broken up under the Sherman Antitrust Act of 1890.
Since obvious monopolies become regulated the modern day monopolies rarely reveal their pricing power for fear of regulation or break up. A few forms of pricing power we have found in recent years have been:
Premiumisation, this is where a premium product provides a buyer with more value relative to other buyers, this is particularly clever because it is not blatantly increasing prices nor is it under delivering the original product it is shifting the relative value not the absolute value. An example of this pricing control is REA Group Ltd in Australia which has introduced premium ads which result in the same spend getting lower advertising rankings.
Product Mix Changes, this is where a pricing card is shifted each year to reduce features at the same price for new buyers. An example of this is Xero Ltd which has reduced the number of invoices you can send on the starting subscription package for several years. Ironically the reverse is also evidence of bad pricing power for example Telstra Ltd which has increased the amount of data, voice calls and text messages you can send for an $80monthly plan for over 10years while multi $B technology has developed from NextG to 5G!
Product Upgrades, this is most evident in software where subscriptions are provided for a duration of time, throughout the period upgrades and new features are provided at no cost, when the subscription reaches renewal the new features justify a price ‘alignment’. A business that uses this approach is ProMedicus Ltd which offers fixed price contracts for 5-7yrs throughout that period new functionality is added, at renewal pricing is aligned for all the new development.
Price reinvestment, this is most powerful when aggregating demand because the continual loop is perpetual and hard to break, more buyers equates to lower prices which leads to more buyers and so on, it also places stress on competitors. Costco and Amazon Prime are the two clearest examples of this charging for memberships while handing back gross margin to customers.
The monopolies throughout history that have had problems have been the aggregators of supply such as AT&T, Standard Oil and Microsoft, this is because it is clearly identified, opposed to Google and Facebook who aggregate demand.
We focus on finding business models that are as capital light as possible ideally needing no capital to grow, We aim to find exceptional businesses that return cash to owners while growing. We want to find businesses that can grow revenue volume without the need to invest in more physical capacity, also while this new volume increases the business profitability. The compounded effect of this is profound and we often find that valuations do not illustrate this long term effect.
To invert the above explanation imagine you own an airline, it is not possible to grow revenue volume (more passengers) without more aircraft, to get more aircraft you need to invest last years profits. At the end of a lifetime of owning a growing airline you would end up owning a lot of old planes and no cash.
Some of the characteristics we see in capital light business models are:
Zero/Immaterial depreciation expense, this means there are minimal tangible assets utilized in the business which implies limited physical limitations for revenue growth.
Intangible product/service, this eliminates the physical need to manufacture something which requires a bill of material, manufacturing assets and logistics infrastructure.
Rapid revenue growth, this is because new volume can be added without physical limitations like having to build a bigger manufacturing line and renting more warehouse space.
Pundits of capital heavy scale operations say that physical assets provide a barrier to entry for new entrants, if there is no capital required anyone can join. While this is true in a physical sense we believe barriers to entry are different than barriers to success, in some ways these are stronger such as Software functionality, Michael Bloomberg famously quotes that 90% of the entire development spend is on the final 10% of functionality that makes all the difference.
Growing Competitive Advantage
The example of buying a castle with the largest moat possible is simple, clearly if you want to keep marauders out you just own the biggest moat, however, once it becomes clear that one castle has the largest moat it is the most sought after and therefore the most expensive. Our approach is investing in businesses where the moat is getting larger and therefore increasing competitive advantage. This also seems obvious however the ‘moat’ comes in varying types and quality and we try to group them into families to understand how they develop and how strong they are, some examples we have found are:
Network effects, we categorize a business as having a network effect when a new user adds value to the existing users. There are several types of network effects but the easiest example in our view is Ebay, sellers list their goods on ebay because of all the buyers and the buyers go to ebay because of all the sellers, more of each increases the other. This is a very deep topic that we enjoy studying.
Install Base, we believe install base business models derive competitive advantage from the cost of switching to an alternative. This cost is in the form of loss of accrued benefit, risk of error or expense. These costs are compounded by more installed units and a longer use period. An example of this is Apple, the more Apple users the more peer support ready to troubleshoot your problems switching would alienate you from this support, the longer you rely on your iPhone the more contacts, data, applications etc you have to lose and the more expensive it becomes.
Friendly middleman network, a FFM is an intermediary that sells the business products to the end customer, the best example is where the product is bundled with FFM expert services and where product characteristics are more important than price. For example you unlikely to go against your surgeons recommendation of a prosthetic hip to implant in your body for a cheaper alternative.
Our Investment Approach