We award businesses an overall quality rating. We will only invest in businesses we rate as “Excellent”, “Very Good” or “Good” (1, 2 and 3 respectively under our quality rating system). The majority of the portfolio comprises of “Excellent” and “Very Good” businesses.
When appraising the quality of a business we assess four key criteria:
Business drivers: Identification of the critical factors that drive the economic performance of the business, and assessing the degree to which they are measurable and predicable and how these drivers are expected to trend over the investment horizon.
Industry structure: Industries which supports shareholder value creation over the investment horizon, taking into account the extent to which there are durable barriers to competition, the degree of consolidation and competitive intensity, the risk of substitutes, potential technological disruption and the regulatory environment.
Business economics and financial strength: Businesses which have robust business economics, particularly those that demonstrate pricing power, high-operating margins, predictable financial performance, high-cash conversion, and high returns on invested capital and incremental invested capital. The financial strength of the business, including the financial risk to equity investors from absolute debt levels, operating leverage and debt structures is assessed and is critical to both portfolio inclusion and the size of the investment in the portfolio.
Management: The capital allocation track record of the Board and management, how they are expected to allocate capital in the future and the structure of incentive compensation and performance parameters are reviewed to assess shareholder alignment.
Investments in “Good” businesses (which still have attractive, above average industry, business and financial attributes) require greater valuation support to increase downside protection. We do not invest in structurally challenged or declining businesses.
When valuing a business, we focus on economic cashflow, not accounting earnings.
We believe valuation is not a science. We therefore focus on a range of expected outcomes based on conservative assumptions (rather than point estimates).
While starting valuation is important, how a company performs over time is critical.