When many investors think about quality, they focus on traditional metrics, such as balance-sheet strength, credit quality and business stability. While these characteristics are important, they are largely backward-looking and do not speak to how the business will perform in the future.
That’s why, when we think of quality, our focus is on durability, which is the company’s ability to sustainably create value over an extended period. The three pillars of a durable business are a strong management team, a sustainable business model, and solid financials.
1. A Strong Management Team
We look for a management team that is aligned with us as shareholders—a team that shares the same principles that we do in terms of long-term value creation. We also like to see management with strong internal ownership of the company’s equity and a long-term record of success.
2. A Sustainable Business Model
Some of the more desirable business characteristics we look for in assessing the sustainability of a business model are high barriers to entry, pricing power, and competitive adjacencies.
High barriers to entry allow a company to grow over a long period, through both good and difficult environments.
Pricing power gives a company the flexibility to increase pricing. That doesn’t mean gouging one’s customers; it means being able to change pricing when necessary to maintain or expand margins. We focus heavily on companies that price their products to a value proposition vs. to the competition’s prices. That way, when an industry hits hard times and we see pricing and margin compression broadly, the company can continue to grow. It creates less cyclicality for the company and in our portfolios overall.
Lastly, we look for companies that have the potential to move into competitive adjacencies, such as new markets. Those adjacencies may not drive near-term growth, but they can be powerful drivers of long-term value creation within a business. Importantly, investors don’t often focus here, because the benefit to the near term can be very limited.
3. Strong Financials
When assessing a company’s financials, key attributes that we look for include a strong balance sheet, recurring revenue, above-average margins, and high returns on invested capital.
Cash flow return on invested capital is a critical measure for us. When reporting earnings, companies have the ability to shift profits from one period to another. In contrast, cash flow return on invested capital lets us better understand what’s actually taking place within the business today as opposed to what accounting metrics may be optically showing.
Ultimately, it is a measure of a company’s ability to profitably deploy its assets over time, and that is a substantial creator of value. For us it’s very important because it allows us to assess the quality of management and whether it is executing on its opportunities.
The Results
If we get the management team and the business model right, the financials end up being a residual. We end up with a company that has a strong balance sheet and more recurring revenue, a company that can work from a position of strength during more difficult environments as opposed to a position of weakness.
That’s why we believe our focus on durability is important. It allows our businesses to not only participate in up markets, but also protect capital during down markets. It gives companies better control over their own destinies.
Dan Crowe, CFA, partner, is a portfolio manager on William Blair’s U.S. Growth Equity team.
Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.
This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions.
