Purist approach to quality investing – well suited to…

“Quality” is a term and investment approach that has been increasingly adopted by investors in recent years due to the proven long-term track record of this investment style. However, the wider adoption has also resulted in inconsistency and impurity in the definition of “quality” used. In growth investments in particular, the boundaries have blurred, as growth has surpassed other styles in recent years.

The Ninety One Global Franchise Fund reflects a purer and more consistent expression of quality that focuses solely on what we believe to be attractively valued top “franchise” businesses. They have the following key attributes: persistent competitive advantage difficult to replicate; dominant market positions in stable growth sectors; low sensitivity to the economic and market cycle; healthy balance sheets and low capital intensity; and sustainable cash generation and effective capital allocation.

Quality in big tech

We are often asked why we do not own any of the ‘FAANG’ stocks when these companies appear to have many of the quality characteristics we are striving for, such as lasting competitive advantages and dominant market positions. The strength of these companies can be seen in the strength of their stock prices, but that doesn’t necessarily make them suitable for our approach to investing. We typically prefer subscriptions to transaction-based revenue models for our tech-driven businesses because they are more consistent, reliable, and less cyclical. We also strive for high and consistent conversion of earnings into cash, strong balance sheets and exemplary capital allocation. In addition, we are aware of the risks of business failure such as platform obsolescence and regulatory risks related to data protection, antitrust law and taxes. After all, even the best companies are not the best investment cases as valuation is also a critical aspect.

One or more of the above issues are currently preventing us from owning any of the FAANG stocks in our portfolio. Instead, our approach favors Microsoft, a big tech company not included in the FAANG acronym. We believe it best fits our approach to big tech. Recurring revenue streams from its subscription-based cloud offering; dominant market position in enterprise software with a firmly anchored global user base; over $ 50 billion in net cash on balance sheet; and sustainable cash flow generation from its platform, which can be scaled and monetized over many years, make Microsoft a convincing investment.

Quality in finance

We prefer companies in the financial sector if they have low-capital business models, highly differentiated competitive positions, structural tailwind or preferably a combination of these characteristics. For this reason, we have long held Moody’s, a dominant player in the oligopolistic credit ratings market, where brand recognition and trust are almost insurmountable barriers for new entrants. The independent ratings market has benefited from structural tailwinds since the global financial crisis as banks around the world reduced their indebtedness and leverage gradually shifted from bank lending to capital markets.

Charles Schwab is another financial stock in the portfolio. We admire the customer-oriented way in which Schwab conducts its business. This approach and continued reinvestment in the customer experience have resulted in significant growth. Schwab now provides brokerage and asset management (among other securities services) to millions of customers and has over $ 7 trillion in client assets.

Quality in inferior end markets

It is interesting to consider how specialized software vendors can offer attractive exposure to some end markets that themselves tend to be of lower quality. For example, while Autodesk operates in the architecture, engineering, and construction industries, it has many of the qualities we want. Autodesk has a leadership position in a number of Computer Aided Design (CAD) software categories for commercial and industrial use cases. This as well as the interoperability between users and projects lead to a permanent competitive position. After a cloud move, Autodesk’s software is largely subscription-based, which means that it is less sensitive to economic and construction cycles. We believe that this portfolio will have a long and profitable growth path in the years to come, supported by positive environmental and regulatory tailwinds. The business is very liquid, has a strong balance sheet and a sensible approach to capital allocation.

outlook

Other than short-term sentiment, we don’t think the environment has changed the fundamentals of our stocks. The companies in the Ninety One Global franchise portfolio are still generating well above average returns on capital, but are now valued at a discount to the broader market that has not been seen in 10 years.

We believe that our consistently purist approach to high quality investing – which is anchored in stocks like Microsoft, Moody’s, Schwab, and Autodesk – can continue to add intrinsic value, and therefore shareholder wealth, and that approach is for both current conditions and for unsafe times are well suited. DM / BM

This article was written by Clyde Rossouw, Co-Head of Quality, Ninety One

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