The Quality Series · part 9 of 13
The only risk that really matters to me is that the business erodes its “quality” and stops compounding. Every facet I look for in a world-class business, everything in the first eight parts of this series, is a defence against that one risk.
While I am by and large industry agnostic and don’t maintain a list of the types of business I won’t own, after two decades, there are some risks that almost always get flagged by my investing checklist, which does the rejecting.
An over-leveraged balance sheet. Hertz was never a world-class business, but it is a textbook case of this risk. On 2 November 2019 I made a prediction on X: “if credit tightens (it will) HTZ is a zero.” As the posts below show, I had argued that the company carried about $16 billion of debt, three-quarters of it raised against its car fleet and on short maturities; that its business model depended on used-car prices holding up; that ride-hailing was taking its customers; and that its free cash flow had been negative by $1 billion in 2018. Less than seven months later, it filed for bankruptcy.
Some borrowing is fine, provided it is affordable and manageable. But a business whose survival depends on refinancing being available has very little control over its own future. A strong balance sheet matters as much as anything else here.
A commodity business. A commodity producer is a price-taker by definition and is therefore exposed to the cyclical nature of commodities. Its fortunes rise and fall with the pendulum of the underlying cycle, regardless of what management does. You saw in part 7 what that does to Freeport’s margins. It also rules out one of the hallmark characteristics of a high-quality business: linearity — the predictable, steady, near-straight rise in cash flow per share I described in part 2.
Profits that depend on policy. Some businesses earn their profits from government policy rather than from their customers: laws, regulation, tax policy, subsidies. For me that is a red flag. All of it can disappear with a change in policy, in legislation or in the administration, and the business has no say in it.
Risk of obsolescence. Kodak had the brand, the scale and the distribution, and it invented the digital camera in 1975. It still went bankrupt in 2012. So I only own businesses where I can be confident they will still be around in ten years or more.
Fashion. This one I learned at my own expense. A couple of years ago, I owned Lululemon. The margins were high, but there were no real barriers to entry. Cheaper competitors copied it, taste changed, and there was a backlash against polyester athleisure. Those high margins with nothing to defend them were a warning I should have heeded going in. However Lululemon fares from here, it is not a business for me. Lesson learned.
One thing my checklist does not reject, and people are often surprised by it, is a great business at too high a price. It has not failed the test. It is simply not an opportunity yet. Whether I am overpaying is a question of its own.
Next: the question that decides everything else, and the most expensive lesson I know about it.
The series so far
- Part 1: The whole idea, in one line
- Part 2: Same five years, very different businesses
- Part 3: From great business to great investment
- Part 4: Where stock returns actually come from
- Part 5: The secret sauce
- Part 6: Why return on capital decides it
- Part 7: A moat is the power to raise prices
- Part 8: Three engines, and the people driving them
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This is my personal investing journal, written for information only. It is not investment advice or a recommendation to buy or sell any security, and it does not take account of your circumstances. I may own shares in companies I write about. Past returns are no guide to future returns.
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