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  • Writer's pictureSean

Why we focus on Quality

Updated: Sep 1, 2022

At Deep Sail Capital we have structured our strategy to take advantage of every identifiable edge that we believe we can reasonably employ. As I described in our Fund Launch Blog Post, at Deep Sail Capital we have three primary areas of focus; Quality, Microcaps, and Special Situations. In this blog post I will describe what we view as "Quality" and why it is a focus of our strategy.


We define Quality as a trait of a business which is measured by the ability to generate abnormally high returns over a long period of time. To achieve this a business needs two things: a moat and a highly profitable business model.


A Wide Moat


Quality has been defined by many investors over the years and each investor has their own opinion on what makes a company high quality. One of the first and most well known descriptions of what makes a company high quality was the idea of a Wide Moat. Originally described by Warren Buffett, a Wide Moat is a company that has a moat similar to a Medieval Castle which was used to protect it from approaching armies. For a company this simply means that it has the ability to protect it's business and it's profit margins from current and/or future competitors. While a high moat is not all that makes a company high quality, we think most high quality businesses at their core need some type of moat or the ability to protect it from competitors. Without a moat, any abnormally high profit margins will be competed away eventually.


There are several types of moats that a business can possess. Not every source of moat is the same. Some moats offer better competitive protection than others. The source of a moat ranges widely and most companies have some type of moat, but most are very very small. Some of the types of moats that we look for are Regulatory Barriers, Patents, High Switching Costs, Network Effects, and Embedded Technology. We try to stay away from Brands as a source of Moat, as Brands in the end are just peoples preferences and those can change over time (example: American Apparel or Abercrombie).


When it comes to Moats, we actually don't think Moats need to be very wide, but rather they need to be very stable and unchanging over time. The rating agencies are a great example of a regulatory and reputational moat that has existed for over a hundred years. Moody's and Standard's & Poor's (as Standard Statistics) have existed since the early 1900s. Overtime their moats have hardened and grown in size due to things like the boom in bond securitization that began in the 1980s and various regulations aimed at protecting companies and citizens that actually created regulatory capture for the rating agencies. The rating agencies moat is extremely stable and wont erode easily over time. This stability of a moat is extremely important as the quality of a business and the longevity of a business are highly correlated.


But a Moat alone is not what makes a high quality business.


A Profitable Model


In order to be considered a High Quality company, you need to have a business model that allows you to continually deliver above average returns on investment. A profitable business model can come in many shapes and sizes, but the key component is an opportunity set that allows for the company to reinvest capital into projects and initiatives that generate returns above their cost of capital. In practice determining the profitability of a business model is both a qualitative and quantitative exercise, especially when trying to forecast it into the future.


On both the Qualitative and Quantitative side of assessing a business model we look at several factors to access both the underlying business and the company's management.


Qualitative Factors we look at:

  • How do they compare to peers in terms of strategy, product offering, and pricing

  • What is the customer and employee satisfaction

  • How have they allocated capital historically

  • Do they have a stated Capital Allocation strategy

  • Does management understand their business model, how they can gain efficiencies, and what are the key levers they control

Quantitative factors we look at:

  • Profit Margin trends over time with an emphasis on Gross Margins

  • Returns on Capital

  • Scale of the business relative to TAM

  • TAM growth over time

  • Growth Metrics

Due to the wide range of industries that we focus on many different metrics need to be used to assess different businesses. There is no one framework that we rigidly apply across every business we analyze.


Once established a company with a profitable business model and a stable moat is an extremely attractive investment.


Why we care about Quality


The reason we care about quality as long term investors, is that the quality of a business and the longevity of a business are highly correlated.


It is pretty well established in the investment community that Quality is a distinct investment factor that has been shown to outperform historically over the broader market. Two recent papers "Global Return Premiums on Earnings Quality, Value, and Size" and "The Excess Returns of 'Quality' Stocks: A Behavioral Anomaly" describe the quality factor and it's outperformance in detail. Quality as it is shown in these papers is best described as some combination of High ROIC, High Gross Margin, and High cashflow/assets. We have come to the conclusion that Quality is important for three reasons.


1) Quality is persistent over time. This concept is best shown visually in McKinsey's Valuation: Measuring and Managing the Value of Companies. In this case ROIC is used as a proxy for high quality businesses. High ROIC (Quality) businesses tend to remain High ROIC (Quality) businesses over long periods of time.



2) Quality Outperforms. As shown in the the recent academic studies I referenced above, Quality as a factor has been shown to outperform the broader market by ~2-3% depending on the geography and time period you look at. In combination with other factors like the Size Factor (SMB), Quality outperforms at an even higher rate. In these studies the Quality factor is defined in multiple ways but the main three are Cashflow/Assets, ROIC, and High Profitability (usually Gross Profit). All of these variations show a significant positive alpha to the market but almost as important they do so with a lower volatility than the market. Quality, not only Outperforms, it outperforms while having a lower volatility and thus a higher Sharpe ratio than the rest of the market.



3) Combining Quality and Reinvestment / Growth grows your terminal value. Highly profitable businesses that have the ability to reinvest their capital at higher rates than the cost of that capital inherently must be creating value. As quality businesses grow their revenue and profits they grow their terminal value, or put another way they compound their terminal value. Combining high growth with high returns on capital (ROC) can yield incredible long term value creation.



All of these individual data points combine together to make us very confident in our focus on Quality Companies.


Sean

Manager - Deep Sail Capital

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