Quality Companies Shine during Slowdowns and over the Long Term

One of the core pillars of our investment philosophy is to invest in high quality companies, which exhibit strong competitive advantages that support sustainable earnings growth over time. The reason that quality companies can generate sustainable growth is that they offer superior returns on capital to their peers and have opportunities to reinvest to further enhance their relative competitive standing, which becomes a reinforcing cycle.

The virtues of investing in quality companies are well documented and is an effective way of compounding capital over the full economic cycle. Importantly, this approach has delivered strong relative returns during both economic slowdowns and recovery periods as the chart below illustrates. The chart shows the relative performance of the MSCI World Quality Index compared with the broader share market and is compared against the Manufacturing PMI Index, an indicator of economic expansion (green dots) and contraction (red dots).

The key conclusions from the chart below is two-fold: (1) the relative return (black line) is upward sloping over the last 24 years (showing outperformance of quality versus the broader market over the long term) and (2) during difficult market conditions such as contractions and slowdowns quality investments outperform the broader market.

Examples of Quality Companies

Next, we look at a few of our favourite companies that we believe exhibit quality characteristics, which will continue to support sustainable earnings growth today and well into the future.

Firstly, a company that provides software products to millions of individuals and businesses across the planet – Microsoft. The trends supporting Microsoft include the rapid increase in cloud computing (physically centralised computing warehouses) and remote working (Microsoft Office Desktop Software including virtual communication platform Teams).

Microsoft operates its Office platform as a monopoly, and in recent years has become ever more profitable and predictable via its subscription business model. Under this model, Microsoft can increase its fees to customers at a steady rate, and with virtually no competition its users have little choice but to pay the annual subscription fee. Microsoft has built an impressive economic moat primarily via continuous development of its applications, which make its products an essential part of daily life for individuals and businesses the world over. In addition, the company can leverage its vast customer base into its cloud computing services – which is supporting sustainable double digit earnings growth rates. This commanding position has allowed Microsoft to generate high return on capital (40%) and strong earnings growth (25% per annum over the last 5 years, see chart below).

We think the trends powering Microsoft’s growth are likely to persist over the long term, and the company’s management team has demonstrated its ability to innovate and execute ultimately delivering strong shareholder outcomes (25% per annum over the last 5 years).

Above: Microsoft has delivered strong earnings and share price growth over the last 10 years. The recent share price sell off is overdone in our opinion.

The next example of one of our favourite long term quality holdings is REA Group. REA Group owns realestate.com.au, as well as holdings in several comparable international property platforms. This is also a company with an impressive economic moat, acquired by the network effect of being the prime location for both buyers and seller across the Australian property market. This is reflected in REA Group’s financial metrics, with an operating margin consistently in the range of mid-40% range.

The REA share price has come off due to rising interest rates and concerns of a property market slowdown. While a severe property market correction would likely have an impact on the business (and the whole economy), there are offsetting factors that are beneficial to REA. Firstly, an increase in supply of homes to be sold will result in increased listings, a primary driver of revenue. Secondly, as property market turnover slows the time to sell leads to increased demand for premium ads, which is a boost to REA revenue and margins.

We think a property market slowdown is presenting long term investors with an opportunity to buy a high-quality company at a reasonable price.

Above: REA Group has delivered strong earnings and share price growth over the last 10 years, even through the property market slowdown of 2018.

Our View

We believe one of the best ways long term investors can create sustainable and robust portfolios is to focus on quality companies. The recent market sell off has created heightened volatility and opportunities for investors to acquire quality companies at an attractive price. History has shown that quality companies are well placed to withstand periods of slower economic growth and throughout the full market cycle.

If you wish to discuss any concerns about the current market or about any strategies to do with your financial plans, do not hesitate to call your Financial Adviser.