The Crown Club: Part 1

This is the first in a series profiling what we believe to be South Africa (SA)’s best businesses. Given that this is inherently a subjective assessment, it is necessary to first set out the qualities we look for in a company that would qualify for this elite list. Not all of these will be companies that we own – while business quality is an important determinant of investment outcomes, so too is the price you pay for an asset.

The best businesses in the world have enduring competitive advantages – or moats – that enable them to achieve above-average revenue growth, earn an appropriate return on capital and generate cash. Strong capital allocation and an excellent management team are crucial here, especially in an increasingly digital world.

WHAT IS A MOAT?

A moat is a company’s competitive advantage – the quality that sets it apart from peers and, if invested in sufficiently, can continue to grow over time. Moats can take many forms: brand power, scale, network effects, regulatory advantages, cost position, leading digital capabilities and technological superiority. Most need to be consistently invested in to ensure they persist over the long term. From our perspective, we spend a great deal of time assessing how well companies have invested in their businesses and whether they continue to do so. Equally important is whether competitors are successfully eroding a company’s competitive advantage. A moat that is shrinking is worth far less than one that is growing.

While moats often manifest as pricing power, this is not always the case. An ultra-low cost of doing business can be a moat in a commoditised sector with no pricing power, while an extremely strong brand can be a moat in the luxury goods sector where pricing power reigns supreme. Both are attractive qualities in a business.

THE GROWTH FACTOR

A company that cannot grow its revenue will eventually be unable to generate attractive returns for shareholders. From our perspective, the most important kind of growth is organic revenue growth. This highlights the true opportunity set ahead of a business and often needs to be teased out from reported financials in order to be properly understood. While some investors tend to focus on earnings growth, we believe that, in the absence of strong topline growth, this is typically lower quality or of a shorter duration than long-term above-average revenue growth.

When making long-term investment decisions, we are effectively being asked to underwrite the outlook for profitable growth from a particular business into perpetuity. Very few companies can sustain high levels of organic revenue growth for extended periods (10+ years). Those that can tend to be exceptional investments. A company can have a small but growing market share, or it can be a participant in an industry that is taking share of the broader economy. Revenue growth comprises volumes and price. A company growing its volumes can increase its scale, reduce unit costs, and grow its competitive moat. Some moats enable a company to exhibit strong pricing power, but this needs to be managed carefully in order to keep out competition and retain the customer value proposition.

The range of organic revenue growth outcomes is very wide, as Figure 1 clearly illustrates. Given that SA is a low-growth economy with high administered expense inflation, companies unable to grow above nominal GDP are very likely to see margin pressure. The hurdle to invest in these businesses needs to be considerably higher than for companies with stronger organic growth prospects.

THE POTENTIAL RETURN ON CAPITAL

All the revenue growth in the world is meaningless unless it can be achieved at an appropriate return. Companies can have reasonable revenue growth but a declining return on capital, which means the capital invested to achieve that growth is generating incrementally less value. This nuance is important: We want to be invested in companies with strong returns on capital that are meaningfully above their cost of capital. A core question is, does the business have attractive opportunities to deploy capital at high incremental returns? This is often the key difference between a compounder and a value trap masquerading as one.

Importantly, these excess returns need to be generated at an appropriate level of gearing. Companies that rely on excessive leverage to produce good returns are inherently less resilient. Typically, companies with a strong moat and growing revenue will also have strong returns on capital. Like revenue growth, the range of outcomes for return on equity is wide, as shown in Figure 2. Additionally, the majority of companies do not even exceed their cost of capital.

THE CASH GENERATION CYCLE

Cash generation is important when assessing the fundamentals of a business. As with the other parameters, where a company sits in its growth lifecycle will shape expectations. Early-stage growth businesses tend to consume significant cash, for example. In these cases, we need to be convinced that the underlying economics of the business, such as margins and capital expenditure at scale, will, ultimately, lead to strong cash generation. The average company converts roughly 70% of its accounting earnings into free cash flow. The higher a company’s sustainable level of free cash flow conversion, the higher the quality of those earnings. Once a company has generated free cash, what it does with it comes to the fore.

APPROPRIATE ALLOCATION OF CAPITAL

Returning capital to shareholders is a key leg of any investment case, but there is always a balance between returning capital and investing in the business. A high-growth business needs to be more focused on investing internally in order to capitalise on the opportunity set ahead of it. Expecting high dividend payouts from businesses in this phase of their lifecycle would be premature.

When it comes to more mature businesses, we start to expect a higher return of capital to shareholders. Companies that no longer have strong organic revenue growth opportunities ahead of them can differentiate themselves through higher dividend payouts or share buybacks. Management teams that truly understand how shareholder value can be created through disciplined capital returns are very valuable – and few and far between. Too often, a compelling total return story is squandered in a large-scale merger or acquisition, frequently in completely new regions or industries.

EXCELLENT MANAGEMENT IS ESSENTIAL

Conventional wisdom used to dictate that a great business could survive a few bad management teams. Warren Buffett famously mentioned that he wants to invest in companies that are so good ‘even a ham sandwich could run’ them. We believe that this emphatically no longer applies due to the rapid changes the digital revolution has brought to how businesses operate. Never before has the competitive landscape been as dynamic as it is now. Excellent management teams know everything about their businesses, understand capital allocation, and are leaders in the digital arena. This allows them to stay ahead of competitors while navigating a complex operating environment. While excellent management teams can often find themselves managing mediocre businesses, true value creation occurs when they combine with great businesses.

Many of these hallmarks of a great business are interconnected, which is what one would expect. A key lesson from our experience is that the best companies are not ‘slightly better’ than average or poor companies – the gap is very large, and this needs to be reflected in the multiple we are willing to pay. These qualities are not lost on the market, with high short-term multiples demanded for the best businesses. A short-term price-to-earnings multiple, however, is a vast oversimplification and fails to capture both the potential for sustainable above-average growth and the fact that great companies run by excellent management teams tend to exceed one’s expectations. The inverse is true for mediocre businesses. We hope to profile several of the great businesses that make it into what we are calling The Crown Club.

Note: The next edition of Corospondent will feature our analysis of AdvTech and why it belongs in this elite group of companies.

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