Finding high-quality companies is an essential component of many equity strategies. But with revolutionary forces sweeping through key industries, what really defines quality stocks? Investors must think proactively about how to identify quality in a changing world.
Growth investors typically search for companies with business models that can stand the test of time. While the essence of the search hasn’t changed, the questions that need to be asked today aren’t the same as yesterday, especially as renewed market volatility will put all stocks to the test. In a world of accelerating change—from Amazon’s rise to the digitalization of countless markets—discovering true quality requires constant refining. Asking the following three questions can provide good guidance about the staying power of investment candidates.
Is Management in Denial?
Perhaps the biggest test of leadership is to acknowledge the threatening forces at your doorstep. Large, dominant companies often overestimate their immunity to change. And we’ve all seen what happens to companies like Blockbuster Video and Kodak, who remained in denial about transformational change until it was too late. When researching stocks today, it’s vital to ensure that a company’s management really grasps what’s happening in its backyard.
For example, we recently heard a senior executive from Johnson & Johnson explain how traditional barriers to entry in consumer businesses are crumbling as small companies challenge giants with cheap contract manufacturing and digital access to consumers. While these developments are well known, major consumer companies rarely express full awareness of the threats that they’re facing. Being alert is a good sign that a company is prepared to adapt to change.
Are Revenue Streams Real?
Companies under pressure can pull many tricks to mask the strain. So it’s important to scrutinize the top line of income and ensure that a company’s margins aren’t being competed away. If a luxury-goods manufacturer is growing its top line by 10% a year, find out whether the company is selling more handbags or simply pushing up the price of existing products. Raising prices isn’t a sustainable strategy to fend off competitive threats.
Take a close look at recurring revenue streams. In a world of change, businesses that operate like toll booths on highways have staying power. In other words, look for companies with a stream of captive customers who will make a purchase no matter what environment they’re facing. But make sure that nobody is building a freeway alongside your tollway. For example, companies like Western Union have enjoyed toll-booth status for their payment systems for years, but face real challenges from free money-transfer newcomers like Venmo. Even pharmaceutical companies with a blockbuster drug that has provided steady revenue flows for years can easily be upended by an unexpected rival.
Will a Dominant Position Persist?
Make sure the company has products that aren’t being competed away. Watch for innovations that could encroach on a company’s addressable markets. Barriers to entry that were once high might not be so high anymore. Anheuser-Busch may be the world’s leading brewer, but the proliferation of microbreweries around the world presents new risks. Investors need to query whether its strategy of snapping up smaller competitors will help it maintain its position—or backfire if consumers shun large-company ownership of smaller brands.
Customer concentration can also be a telltale sign of weakness in a changing market. Businesses that depend on one or two major customers can be vulnerable to problematic pricing negotiations if new competitors emerge.
Businesses that benefit from network effects should be well positioned in a changing world. Amazon, Google and Facebook are all companies that persistently widen their moat versus peers with services that continually draw in increasing numbers of customers.
Above all, innovation is indispensable. Companies that dominate markets cannot assume they will prevail in the future without demonstrating an ability to reinvent their products and services as their market conditions change.
Ask the Tough Questions
The answers to these questions will vary by sector, industry and individual company. But investors can’t avoid asking the tough questions today. Highly valued stocks of companies that are misperceived to have high-quality businesses could be vulnerable in a market crisis. By continually reassessing the characteristics of quality, we believe investors can identify stocks with strong long-term performance potential through changing market conditions.
