The cardinal mistake in investing is to lose a lot of money. Obviously, nobody loses money willingly, so what is the X factor that trips them up? Quality—or, more specifically, misunderstanding quality. This chapter outlines the counterintuitive framework you need to assess quality correctly.
The contrarian pays more attention to researching what can go wrong than what can go right. This chapter shows how to look out for fads and frauds, which are nothing other than failures masquerading as successes. BlackBerry is presented as a case study of a fad masquerading as a franchise. Could Apple be next?
The X Factor: Quality
Just as prevention is better than a cure, avoiding mistakes is smarter than having to fix them. In investing, the cardinal mistake is to lose a lot of money. Obviously, nobody loses money willingly or knowingly, so the question is: What causes people to lose money unexpectedly and unwittingly?
The answer is quality—or, more specifically, a misconception of quality.
Identifying quality is more complex and nuanced than most people realize. In fact, the financial crisis of 2008 was nothing but a series of revelations that quality had been massively misjudged—by bond and equity markets, by investors, by management teams, by regulators, and by rating agencies. Institutions and instruments previously rated AAA fell like dominoes because perceptions of quality did not match the revealed reality.
The fact that so many smart people got it wrong should tell you that distinguishing genuine quality from deceptive quality is not as straightforward as it seems. Partly this is because conventional wisdom, which works so well in life, works very poorly in investing. In your day-to-day choices, it is perfectly reasonable to extrapolate your past performance into the future. Not so in investing. Even though a stock may have gone up in the past few years, that does not mean it will perform well in years to come. Sony was once the Apple of Japan, flying high on a string of global hits with the Walkman and the Discman. But change, competition, and complacency ensure that the apple carts of winners and losers often get upset, upended, or even swapped around.
To make matters worse, conventional thinking not only fails to diagnose quality, it often leads you to misdiagnose it, giving you the equivalent of a false positive or a false negative medical test result. In the investment world, making decisions based on misleading assumptions or wrong answers can put you in serious jeopardy. Not only will you not make money, you will lose it, and potentially lots of it. On the other hand, correctly understanding quality yields tremendous bang for the buck. It not only helps you avoid losers; it also helps you pick winners.
If the quality of the underlying business is better than commonly understood, chances are the stock is mispriced and undervalued. Arbitraging the difference between the two is either your gain (if you correctly understood the quality attributes) or your loss (if you misunderstood them). Therein lies the trick and the treat: If you get it right (and prove others wrong), you win; get it wrong, and you lose.
Yet, even though understanding quality is so critical, few people get it right. People who think they just know quality when they see it usually don’t. This is because quality is made up of many interlocking parts. It’s far too complex for simple formulas or checklists. The biggest challenge in investing is that low quality often masquerades as high quality, and vice versa. In the following pages, I will show you how to avoid falling into the trap of conventional thinking, which confuses low quality with high quality, and embrace the power of counterintuitive thinking, which correctly distinguishes between the two.
Signposts or Red Herrings?
We humans are reductionist by nature. We gravitate toward simplicity, sometimes at great cost. So when we think about quality, we automatically associate it with familiar rubrics—a brand, a competitive advantage, a captive client base, or a dominant market position. Or we tell ourselves that quality shows itself as pricing power or high profit margins. On the face of it, these depictions seem correct. What can possibly be wrong with it?
How about everything?
Indeed, these classic buzzwords of quality are some of the false positives I cautioned you about. To think like a contrarian, you need to examine the counterfactual. Ask yourself this: If brand signifies quality, why did the stocks of iconic brands such as Macy’s, Sears, and Marks and Spencer get pummeled in the markets?
If pricing power is a litmus test of quality, should you own the (loss-making) U.S. Postal Service because they have always raised stamp prices and never once lowered them?
How about owning the telecom companies that had such dominant market share that they had to be broken up? Does anybody even remember what happened to the Baby Bells? Where did their dominance go?
You get the drift. Many of the traditional gauges of quality can be head fakes. So how do you go about separating the reality from the red herrings, the crucial from the superficial? For that, we need to turn to some case studies that will help rewire your brain to a different, more non-consensus way of thinking.
Frothy Skim Milk Versus Cream: A Case of Quality That Was Not
Do you remember the company that made BlackBerry phones? Research in Motion (RIM) was its name (since changed to BlackBerry Ltd.), and back in the early 1990s, this company epitomized quality.
In those pre-smartphone days, the 2G cellular network was optimized to carry voice, not data, so the network would get clogged with calls competing with texts or emails, and calls would drop. But RIM had an edge over its competitors: they had figured out a way to compress the data in such a way that BlackBerry phones could efficiently transmit it without unduly congesting the network, thereby avoiding dropped calls. RIM’s proprietary technology not only compressed data, it also encrypted it, which made it safe to use by both enterprises and government agencies. BlackBerry naturally became the go-to device for these organizations, and soon made its way into the consumer mass market.
To anyone looking at the financial metrics, the company was on fire, with high growth and high returns. You are probably familiar with Porter’s Five Forces: industry rivalry, threat of new entrants, threat of substitutes, bargaining power of suppliers, and the power of customers.1 RIM could have been a mascot for Professor Porter; it checked all the boxes.
• It had a dominant product and very few rivals.
• Thanks to its proprietary encryption and compression technology, there were no threats of substitutes.
• Its utility and uniqueness resulted in a strong bargaining position with its suppliers and customers.
• It was able to charge premium prices for its services and devices.
Because of all that, RIM enjoyed spectacular earnings growth and a stock price that soared from a low of $1.42 on October 10, 2002, to a high of $145 on June 20, 2008—a gain of roughly 100 times in less than six years!
If that was not a quality business, what was?
Yet RIM turned out to be the biggest booby trap of all: a low-quality company masquerading as high-quality. And it fooled a lot of investors. Neither RIM’s brand nor its competitive advantages helped it withstand the onslaught of something so simple and inevitable that anyone could have seen it coming—the force of change.
With the arrival of 3G and 4G cellular networks, which were optimized to transmit data more efficiently than the older 2G network, RIM did not lose its moat—its moat became irrelevant, and the company became marginalized in the marketplace. Its quality, once priced as a lasting franchise, was revealed to be a passing fad.
If you misdiagnosed RIM’s true quality—and many did—you lost a lot of money. From its peak in June 2008 through June 2017, the $100 stock had fallen to $10. To break even from such a losing investment, you would need another investment idea that would go up a whopping 900 percent. That is a very tall order. Better to not lose 90 percent in the first place. This explains why avoiding losers should be the primary aim, not an afterthought (as we learned in chapter 6: do no harm).
Why didn’t anyone see beyond RIM’s financial metrics? Because as conventional thinkers people are accustomed to judging quality by tangible measures like profit margins and earnings growth, or by intangibles such as a brand. But neither of these was a litmus test of enduring quality. To understand quality, we must look beyond the horizon and around the bend, because quality isn’t a simple label but a latticework of interlocking attributes.
Your Secret Weapon in the Quest for Quality: Ask “Why,” Not “What”
If you judged RIM by numbers alone, it looked fantastic. But the moment you broadened your perspective, what appeared to be surefire quality started to look vulnerable. That is what happens when investors are too easily satisfied with understanding the “what” instead of going deeper into the “why.” The question is not “What is their market share?” but “Why do they have that market share?” Not “What is the profit margin?” but “Why do they have that profit margin?” “Why” provides the missing link that goes past the symptom to the source.
Taking a page from Socrates, I have developed a mantra of five whys: Why after why after why after why after why. This relentless line of inquiry enables me—and you—to conduct a root-cause analysis to correctly distinguish between high and low quality. It goes like this:
1. Why did the BlackBerry succeed? It could compress data into compact packets. This technological capability was highly desirable when consumers started to switch from plain text messaging to longer emails, causing congestion in a 2G network designed to carry voice, not data.
2. Why would their success last? It would not. The next-generation networks (3G, 4G, 5G, etc.) were better optimized to carry data and not just voice.
3. Why would their product remain competitively advantaged and differentiated? It would not. The cellular network, not the (BlackBerry) device, would solve the problem of congestion.
4. Why would they make superior revenues, margins, and returns in the future? Contrary to consensus expectations, they were likely to experience a collapse of market share, revenues, and profits as their core technological advantage and differentiation became irrelevant.
5. Why would the stock go up? It wouldn’t. In fact, it would go down as telecom companies deployed next-generation (3G, 4G, 5G) networks and the company started to lose market share and miss earnings expectations. Investors would figure out that BlackBerry’s best days were behind them.
By asking the right questions, I uncovered a bleak future. Other investors extrapolated a bright future because they focused on the financial model (which looked great at the time) but neglected the emerging threat to the business model.
This case study underscores how conventional wisdom does not prepare you for inflection points—game-changing developments where the future may be dramatically different from the past. This is what makes investing such a tough puzzle: it is challenging to fathom and forecast change or anticipate winners turning into losers. Mastering it requires rewiring the way you think and how you interpret and react to information. If you do not proactively find the blind spots in your research, you do not even know what is about to hit you. In investing, what you do not know is often more important than what you do.
Understanding the ins and outs of an industry and keeping tabs on where it is headed is a good starting point to reduce the risk of being blind-sided. This can then be extended to understanding the food chain and value chain of various players in that industry. Last but not least, you need to develop a good appreciation of every player’s capabilities, competitive positioning, and business strategy. Management quality and track record also need to be judged. Beyond that, risk factors and growth prospects need to be carefully evaluated and quantified. If all this sounds like a lot of work to vet a single investment idea—it is! But those who can garner the necessary knowledge and apply it can profit from those who can’t.
The BlackBerry case study also epitomizes another lesson. Many value investors bought RIM’s stock on the way down, believing it to be cheap (underpriced) based on financial metrics and multiples. They repeated this mistake when they bought bank stocks as they were falling in 2008, using the same circular logic of cheapness. Historical financial numbers or naïve valuation metrics such as low price-to-book or price-to-earnings ratios will not tell you that the quality of the underlying business is about to deteriorate. Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
This is what makes non-consensus investing quite different from rote approaches to value investing. Non-consensus investors care about what they are getting (the quality of the underlying business), not just what they are paying (the headline valuation metric). Other types of value investors care predominantly about what they are paying, not about what they are getting—which is why they often end up owning a value trap rather than a value bargain. Knowing how to correctly distinguish quality from junk is a prerequisite to generating higher returns with lower risk—which is a central aspiration of non-consensus investing.
This next section will debunk many of the conventional criteria that are commonly used to assess quality and give you the contrarian but correct ways of thinking about it. I have peppered the section with actual case studies, so you can see real-life applications of this concept. It is worth reiterating that all stock examples or theses expressed are meant to be illustrations, not recommendations.
Ten Myths and Truths About Quality
Let’s start with a summary chart, table 7.1. On the left are ten familiar but flawed indicators of quality. These overused, empty buzzwords are red herrings leading you astray. On the right is a corresponding list of real and reliable ways to gauge genuine quality. We will look at each one in depth.
1 Charles Darwin, was an English naturalist, geologist, and biologist. He is best known for his contributions to the science of evolution which he argued resulted from a process of natural selection through adaptation or more colloqially known as “survival of the fittest”. He published his findings in 1859 in the now-classic book On the Origin of Species which was translated into many languages. During his lifetime, the book become a staple scientific text but also resonated with people from all walks of life, becoming a key fixture of popular culture.
Competitive Advantage Is Overrated
In fact, “competitive advantage” is a misnomer. To be a high-quality business, it is not enough to beat the competition today; you must also remain competitive and relevant tomorrow. That requires a Darwinian advantage.
You know the phrase “survival of the fittest.” What Charles Darwin meant was not that the strongest or smartest of the species survive, which is how most people interpret it. It is those who are most capable of adapting to their environments over time who gain the upper hand. The same is true of a business. A so-called competitive advantage will take you only so far. To succeed, you cannot have just one ace up your sleeve; you need many intertwined capabilities. That is your Darwinian advantage.
Take Kodak and Fuji, for example (figure 7.1). They were rivals for years. Kodak had the advantage in the world of analog film, but as digital technology disrupted the film business, the company failed to evolve. Like Kodak, Fuji faced the same existential headwinds as its analog film business also faced digital threats. But unlike Kodak, Fuji adapted and built evolutionary advantage by applying its knowledge of chemistry and film coatings to new applications and end markets. Today, Fuji is thriving, with multiple streams of earnings ranging from high-tech copier toner to film coatings for LCD panels used in TVs.
In building evolutionary advantage by adapting to a new world, Fuji rose to new heights while Kodak self-destructed by depending on its limited, point-in-time competitive advantage. Darwinian advantage yields lasting quality; competitive advantage represents lazy quality.
People are quick to talk about a company’s high profitability as a metric of success. But over time, capitalism dictates that excess profits will get competed away. The longer you can prevent this from happening, by building Darwinian advantages that keep competition at bay, the longer you can earn excess returns. That is earnings power with staying power.
Competitive advantage focuses mostly on barriers to entry, which may prove short lived. Darwinian advantage is about continuously raising the bar not just on barriers to entry but also on barriers to success. It’s a process of developing interlocking advantages that are layered on top of one another to provide a wide and long lead over the competition.
Toyota does this by deploying kaizen, a system of continuous improvement, on a whole host of fronts, from investing in superior engine technology to implementing just-in-time manufacturing to cross-training workers to developing best-in-class global supply chains and manufacturing footprints to delivering a high-quality yet low-cost, reliable, and durable product to its consumers. Competitors can try to take on Toyota on any one plank, but to surpass it on all fronts requires heroic resources and capabilities that most companies would be hard pressed to marshal. Better to pick a weaker competitor than to take on the strongest and most adaptable.
The Myth of Market Share
Now let us consider the smoke and mirrors of leading market share versus the more powerful indicator of quality: growing market share.
Baby Bells in the United States used to enjoy leading market share in the telecommunications industry. But their lead did not last because they took it for granted and failed to invest in next-generation networks to deliver broadband data connectivity and high-speed internet. The cable-TV industry sensed an opportunity and outsmarted the telecom incumbents by investing in a high-speed network that could carry both pay TV and high-speed data/internet. That meant they could add telephone services at low marginal cost. Many Americans now get triple-play services (voice telephony, high-speed broadband, and pay TV) from their local cable-TV company, and the once-dominant telecom companies have been relegated to losing market share instead of expanding it. Not surprisingly, many cable-TV stocks have been star performers while telecom stocks have lagged.
Now, I would not want you to construe this as an invitation to buy any challenger business model that is expanding its market share. This case study is meant to be a reminder of how conventional frameworks that equate high market share with quality is a false positive. Indeed, we appear to be on the cusp of another big shift. The cable-TV business model itself is being upended by new challengers, such as Netflix, that are expanding their market share by offering better value propositions to consumers. In contrast, cable companies keep raising prices, which sends customers in search of more compelling alternatives such as Hulu or Disney+, a new soon-to-be-launched video streaming subscription service by Disney.
While expanding market share is better than not, it is a means to an end, not an end in itself. Pursuit of market share should not come at the expense of developing strategic advantage and pursuing long-run profits. Markets are dynamic, and winners and losers are continuously shifting. Companies that assiduously focus on offering consumers compelling value propositions get rewarded and win market share, while those that simply make hay while the sun shines ultimately prove to be lazy, not lasting, quality.
The Myths of Pricing Power and Captive Customers
Many people believe that pricing power or captive customers are unambiguous signs of quality. But they may not be.
Recall that legacy airline carriers in many countries had pricing power—not because they ran their business well but because they had a monopolistic hold over prime routes and airport landing slots. They abused that power by keeping prices high. You know what happened next. Upstarts such as Southwest in the United States, Ryanair in Europe, and WestJet in Canada jumped in to develop low-cost airlines and gain customers by lowering fares instead of raising them.
The point to remember is that soaring prices can become a source of vulnerability, rather than a symbol of strength, if consumers balk at the deteriorating value proposition. Case in point: Gillette. For years, it regularly raised prices, seeming immune to the laws of gravity. Then in 2016, it got a rude reality check when consumers began moving in droves to the upstart alternative, Dollar Shave Club. Gillette was forced to lower prices. Quality may not necessarily be defined by who can raise prices but by who can lower them.
Companies that can lower costs and offer more for less may be the success stories of tomorrow. Silicon Valley readily comes to mind here, but there are examples even in the traditional manufacturing sector. This was the case with Rational, a Mittelstand (midsize German company) renowned for making the best industrial-grade convection ovens for the hospitality industry. For decades, despite constant product improvement, it had spurned the easy path of raising prices. By offering such unbeatable value to its customers, it raised the bar for the competition, not its prices. This kept the customers happy and kept the competition at bay. Result? In the decade that ended in May 2018, Rational stock has increased tenfold.
Another marker of quality is repeat purchases by customers. But beware: if the cause of the repeat purchase is lack of choice, this measure becomes meaningless. Remember that many legacy telecom companies took their captive customers for granted and neglected to provide value. They mistook captive customers, who had nowhere else to go, for loyal customers. The moment those customers got a choice, they shifted their business en masse, exposing the business model for the low quality that it was. Captivity is not loyalty. High-quality businesses are those where customers willingly do business even if they could go elsewhere, because they are getting real value for their money.
Brands May Be Overrated
Businesses spend billions of marketing dollars every year on brand recognition. Unfortunately, the size of marketing spend is no guarantee that the brand will always be on top. No amount of advertising or public relations can rejuvenate a brand when the product itself does not live up to the promise. Look at (figure 7.2). It was once an iconic cosmetic brand and remains well known even today, but that did not protect it from weak consumer demand. The businesses suffered, and so did the stock. From December 2007 to December 2018, Avon stock fell more than 90 percent while the S&P 500 has gone up by almost 66 percent over the same time frame.
The worst offenders are those that rely excessively on their brands to do the heavy lifting of increasing revenues. Abercrombie & Fitch thought it could buck the trend by relying on its brand to justify high prices when its peers were offering far more compelling product or value propositions. After consumers gasped from sticker shock, the company debased its signature label by offering widespread discounts and ongoing promotions. The stock collapsed as the halo around the brand evaporated. Abercrombie & Fitch had pricing power—until it did not.
This is why I am not a fan of ascribing value to brands as a special asset on the balance sheet. Not only can they be ephemeral and hard to estimate, this practice may be tantamount to double counting. The value of the brand is implicitly captured in the revenues, earnings, and cash flows of the company, so the contribution is already embedded in the valuation of the firm.
Also note that many consumers are starting to care more about the authenticity and origin of a product than just its brand. The Muji brand (the word translates to “no logo” or “no brand” in Japanese) has become a runaway success worldwide by offering a minimalist design at affordable prices. Muji devotes little money to advertising or traditional marketing, relying instead on word of mouth, a simple shopping experience, and the anti-brand movement. Muji’s no-brand strategy also means its products are attractive to customers who prefer unbranded, generic products for aesthetic reasons. Lower branding costs enable lower prices despite the high quality, which in turn results in such a compelling value proposition that customers keep coming back for more. This creates loyalty and provides longevity to a business.
I am not against brands per se but want to point out that what works well in life may not translate well into investing. Familiar household names with strong brands such as Avon and Abercrombie do not necessarily make good investments, while lesser known companies such as Ryohin Keikaku (the company behind the Muji brand) that base their appeal on compelling product attributes may well prove to be the winning ideas.
Over the five years ending in December 2018, Abercrombie stock was down 40 percent and Ryohin Keikaku stock was up more than 130 percent in local currency (figure 7.3).
The trouble with relying on a single metric, even a bedrock attribute such as a brand, is that it makes investors complacent. You may be so in love with the brand that you completely overlook deeper problems, such as deteriorating product quality or changing market trends. Indeed, Kodak still has a brand that many recognize, but it doesn’t help. Even in the company’s new incarnation, its stock fell from $25 in 2013 to $9 in June 2017.
Understanding true quality requires one to look at subtleties rather than superficialities. Brands, no matter how vivid or familiar they may seem, are not a free pass that lets you ignore deep, full-fledged research on a business. Nor do they offer some innate immunity from failure or loss. Brands are the cost of doing business. They may raise the stakes for new entrants who can’t afford to spend millions on advertising or may buy companies some time and leeway if they face a public relations fiasco, but they are not a magic wand that can ward off all challenges or challengers.2 The product or service must perform and continue to satisfy customer wants or needs.
Judge the Decisions, Not Just the Outcomes
Another red herring that keeps investors going in circles is looking at the quality of outcomes when they should be looking at the quality of the underlying decisions a company makes.
Northern Rock, a mortgage lender in the UK (the equivalent of Countrywide in the United States), was considered a blue-chip stock of its time. Back in the mid-2000s, the company was increasing its earnings and dividends at a rapid clip. It was everybody’s darling, but not mine; I believed it was high risk and low quality. Why? Because it was relying on the cheap but footloose wholesale market to fund its business instead of building a costlier but stickier deposit franchise. At the time, the wholesale funding market was flush with cash and eager to lend, but I knew from long experience that it was a fickle funding source and could prove to be the Achilles heel of the business model.
Two years later, management’s shortsighted decision, to rely on easy money and not develop a stable deposit funding base, put the company in jeopardy. In 2008, when the wholesale funding markets dried up during the financial crisis, the market was stunned (I was not) that Northern Rock was among the first financial institutions to need a government bailout. Then, when the British government nationalized the company, the stock went to zero and investors lost 100 percent of their money. This is the worst kind of loss for a shareholder because you don’t ever get a chance to make it back when the company has gone bankrupt—it is game over (or what I would call “a permanent impairment of capital”). While the going was good, a robust growth rate and a successful financial track record gave the illusion of prosperity at Northern Rock. But if you judged the quality by the decisions the management team made, you knew they were making an extremely poor trade-off between risks and returns.
In stark contrast, consider the decisions made by Toyota, which constantly reinvents itself to survive and prosper in the next century. They do this by reinvesting and reducing risk in the business, even at the expense of current margins and returns. The decision to develop a hybrid engine (powered by both gasoline and a battery) is a good example. Few people realize it today, but this was a tough call for a company that made great gasoline engines. Still, in the long-term interest of consumers and stakeholders, it was the right decision. Indeed, so farsighted was the management team that they were early investors in Tesla, an all-electric car that could be a challenger to its mainstay business.3 Toyota is open to cannibalizing its core competitive advantage to develop a new one, and by constantly moving the goalposts forward, it creates an increasing lead over its competitors, who will find it difficult if not impossible to catch up. Such well-rounded decision-making of paying as much attention to preempting future threats as to availing itself of current opportunities—is a hallmark of a high-quality business.
The superior quality of decisions provides a company with both strength and strategic optionality that it can draw from in tough times. This explains why Toyota remained resilient in the wake of many recent setbacks, including large product recalls on the back of safety concerns in the United States in 2012, and the disruption of its supply chain because of the tsunami in Japan and flooding in Thailand. Its strong net-cash balance sheet, along with the years of trust and goodwill built with its customers, allowed it to overcome multiple challenges without compromising its long-term future.
However, ongoing assessment is needed, because in the marketplace, even the mighty can fall. Recall that Yahoo in its prime sported better financial metrics than Google, but it proved to be a melting ice cube—not an overnight failure, but a trickle over time. If you had evaluated Yahoo by the poor quality of its decisions—such as a failure to invest and improve its search engine, as well as the shortsighted move to maximize ad revenues by bombarding customers with annoying banner ads—you would have concluded that the stock was a trap. And you would have avoided it. Toyota could end up in similar trouble if it does not make the right decisions on next-generation technologies. It has so far bet that hybrids like the Prius, instead of a fully electric vehicle, are the way to go. Time will tell if this decision was sage or shortsighted.
In evaluating management teams, you must assess whether they are pursuing short-term KPIs (Key Performance Indicators) to meet incentive compensation targets, often at the expense of endangering long-term KPIs. It is crucial to know whether management is managing earnings (tends to line their own pockets) or capital (tends to line shareholders’ pockets). Sadly, management incentives are often skewed toward near-term growth of earnings per share, which creates a bias to flatter earnings results today, often at the expense of long-term considerations. Beware of this predilection to shortchange the future for present gain.
In my opinion, this is exactly what played out at Coach (rechristened Tapestry), a premium handbag company. When management found that the profitability of their outlet stores was far greater than that of their high-street ones, they continued to expand their sales through the outlet channel to boost profits. This short-term expediency came back to haunt them, as it came at the expense of the brand’s heritage and premium positioning. Fortunately, the company was wise enough to recognize it had overplayed its hand and corrected its strategy under a new management team. As we will see in chapter 8, Coach is now on its way to restoring its former glory. But this anecdote shows how measuring and managing aimed solely at near-term numbers can be damaging for the long-term health of a business.
Beware of management teams who make low-quality decisions in the name of high quality. One example: Using the proclaimed benefit of “optimal capital structure,” there is a great deal of activism to encourage companies to borrow money to buy back shares, to boost earnings per share. The trouble is that people often confuse cost and risk, so on the surface poor decision-making can temporarily manifest as success. Such practices seem harmless in the good times but can prove very damaging in tough times. Having a cash cushion for a rainy day is good insurance. Borrowing money simply because it is cheap and readily available is not a smart move, as many homeowners discovered during the housing crisis a few years ago. The cost of the decision is not the same as the risk of the decision. Leverage in any form—operating or financial—is a source of risk to equity shareholders, and therefore highly leveraged companies fall squarely in the low-quality camp.
“The cost of the decision is not the same as the risk of the decision.”
Bottom line: Quantitative comparisons of outcomes (such as profitability or growth rates) should not trump qualitative assessments of the drivers of those outcomes. Do not judge companies on their numerical results alone; evaluating quality requires a balanced scorecard. In particular, instead of looking only at results, evaluate management teams on the quality of their decisions and the trade-offs they made that led to those results.
Is It a Buzz Model or a Business Model?
Many disruptive dotcom companies are known for their mouthwatering growth rates as they siphon customers and market shares from lumbering incumbents. You might think such challenger companies are high-quality businesses, but they are not. They appear to be successful in growing market share and revenues, but they are failures when it comes to making money. In fact, they often lose it.
Now, some people will dispute my claim, arguing that they report profits. The catch is that they appear to make money when they use non-GAAP accounting (not generally accepted accounting principles). With non-GAAP accounting, companies can blithely exclude certain legitimate business expenses to flatter results, often converting losses into profits. If you were to recast their earnings using generally accepted accounting principles, they are more likely than not to rack up large losses. Claiming one is profitable on a non-GAAP accounting basis but lossmaking if GAAP accounting is used is akin to a student telling her teacher: “If you exclude all my wrong answers, I would have aced my exam.”
The lesson here is that many people confuse the narrative with the numbers. Simply because a company increases market share and revenues does not mean it makes money. In my opinion, a business that does not make money for shareholders is a buzz model, not a business model. It is best to think of it as a phenomenon to watch rather than a company to invest in. Many dotcom companies that emerged during the Nasdaq bubble period were buzz models that fizzled out, at great cost to their shareholders.
There are many examples; here are just two. Webvan, an online grocery company, went out of business in just three years and filed for bankruptcy in 2001. Pets.com did not last for even two years, despite advertising in the 2000 Super Bowl. It had the zany idea of selling products well below cost and trying to upsell and cross sell its customers to offset such losses. The strategy failed: losses grew faster than sales, and the company went under.
Many people assume a rising stock price is proof of success. This is a classic case of confusing cause and effect. Merely because a company appears successful, does not mean it is. A successful company is one that makes money, not loses it. Watch out for companies that have a big difference between GAAP and non-GAAP earnings (many tech companies in the United States tend to have the biggest divergence due to their widespread reliance on stock-based compensation expenses); it is a huge red-flag indicator of low quality and should give you pause. (The only exception is the owner-operated earnings construct used by Warren Buffett.) Likewise, be alert for huge disparities between reported earnings and free cash flows. This can indicate possible accounting chicanery; at the very least, it calls for the “five whys” interrogation.
Is Growth Driven by Acquisitive or Organic Means?
Companies that spend a significant amount of their own free cash flows in acquiring other companies are often ultimately revealed to be low-quality businesses as the acquisition strategy unravels. I call them serially acquisitive companies. Multiple studies show that most mergers and acquisitions fail to deliver on their targeted synergies or promised benefits; in fact, they invariably prove value destructive.
It is not difficult to understand why. Acquisitions usually suffer from a winner’s curse: you win the auction, but only by paying an inflated price, resulting in a pyrrhic victory. Remember that all acquisitions are made with shareholders’ monies, which means investors pay the high price while the CEO gets to walk away with the prize.
Acquisitions are such an easy way to drive fast growth that they tend to become addictive. Soon companies start leveraging themselves up to fund that addiction. Before long, the company becomes a house of cards. When that happens (and to be clear, it does not always happen), the company dismantles itself, often selling off its crown jewels to pay off debt. The best outcome one can hope for is that the company resets itself on a more organic path, something that they should have done all along. Serial acquirer Pearson Publishing is a textbook case of a debt-funded acquisition spree gone awry. For many years the company acquired companies with borrowed money to drive growth. When the strategy failed, the company found itself in distress and was forced to sell many prized possessions, including the iconic Financial Times and the Economist, to repay parent-company debt.
Serially acquisitive companies also have considerable latitude in creating cookie-jar provisions that enable management teams to manipulate reported earnings or even engage in corporate fraud. Typically, the larger the size of the acquisition, the greater the scope for a copious cookie jar to dip into.
Like a moth fatally attracted to artificial light that can kill it, myopic management teams can be so enamored with acquisitions and exhilarated by the adrenaline rush that comes from frenzied deal-making that they put their entire companies and careers at risk. Tyco under former CEO Dennis Koslowski and Valeant under former CEO Michael Pearson are emblematic of the disastrous consequences of such errant behavior. Both companies generated large losses for investors, and their chief protagonists were put behind bars on charges of corporate fraud.
Some people may argue that not all takeovers are value destructive, and I would certainly agree. Many CEOs are excellent stewards of capital, including when they make acquisitions. But they are so few and far between that I believe it is safe to generalize: serially acquisitive companies are generally poor-quality businesses that prove to be poor-quality investments. One famous exception is Warren Buffett’s Berkshire Hathaway. It makes a lot of acquisitions but does not fit the mold of a serial acquirer. Rather than growth for growth’s sake, Buffett is disciplined and acquires only if the deal represents judicious allocation of capital and adds value. Acquisitions can create value, but that tends to be the exception, not the rule. Think of Warren Buffett as exceptional in this regard—as he is in so many others.
Luck or Skill?
An example of a false positive is the performance of many high-cost basic-resource companies between 2003 and 2007. During this time, prices of copper, iron ore, oil, and similar commodities were so high that even uncompetitive, poorly managed, low-quality companies made a lot of money simply by being exposed to the bull market. If you mistook their luck for skill, you lost a lot of money when the tables turned.
The Brazilian oil and gas company OGX is just such a riches-to-rags saga. The company was formed in 2007 by billionaire Eike Batista, who bombastically claimed he would be worth $100 billion in ten years, which would make him the richest man in the world. Indeed, the initial public offering on June 12, 2008, raised an incredible $4.1 billion, with the promise that the company’s oil ventures would yield a bonanza, despite not yet having produced a drop of oil. Five short years later, Batista filed for bankruptcy and OGX went under, taking shareholders’ money with them.
The lesson here is that winning by default (being in the right place at the right time) is not the same as winning by design (strategically positioning yourself to win against the odds). Luck, in the form of tailwinds and externalities, may confer a fleeting victory to a company or industry but it will not stand the test of time. As commodity prices fell, many companies were forced to retrench, restructure, or even file for bankruptcy. Always ask the question: is this a high-quality business experiencing a tough time or a low-quality business experiencing a good time? The former is an opportunity; the latter is a red flag.
Tangible Patents Versus Intangible Know-How
Investors are typically impressed with companies that own patents but often fail to evaluate a more powerful form of intellectual property—know-how. Patents are tangible but perishable; they eventually expire. They can also be copied (with some tweaks) or challenged in court. Did you know that some of the worst-performing stocks over the past several years, such as Xerox, IBM, and Canon, are some of the largest patent owners? In my experience, patents are overrated, know-how is underrated.
Know-how is accumulated knowledge about a process or technique that is hard to decipher or reverse engineer. That means it can yield a competitive advantage for a long period of time. Consider ceramic resistors and capacitors made by Murata Manufacturing. These components are used in smartphones to minimize interference in the complex electrical circuitry embedded in most modern electronics. We use them every day but do not realize their value because they are not visible. Making a ceramic product is like making pottery. It is a complex mix of engineering design, carefully calibrated composition of materials, as well as the precise duration and temperature at which it is heated in the furnace. This is extremely hard if not impossible to reverse engineer. Such know-how is more precious and less perishable than a patent. Know-how can create high barriers to entry and yield not just superior but supernormal profits in a company.
High Tech Versus Proprietary Tech
In a similar vein as patents, investors often equate high tech with superiority and a marker of a high-quality business, when it may turn out to be the opposite. This is a mistake I made early in my career in the 1990s when investing in petrochemical-refining plants in Asia. I equated their technical complexity with high barriers to entry and competitive advantage. I was right about the facts but wrong about the conclusion. A petrochemical-manufacturing plant is indeed very sophisticated and complex. However, the technology and expertise to build and install the process-automation equipment in the manufacturing plant is owned by their suppliers, such as ABB, Siemens, and Emerson Electric, and they sell it to anyone who wants to buy it. There is nothing exclusive or proprietary about it. This explains why, despite being high-tech, petrochemical plants do not generate good returns on capital invested, which makes them low-quality businesses with poor value-creation prospects.
I almost repeated this research mistake a few years ago in 2013, when I researched State Street’s new IT platform, which they touted as best-in-class and transformational for their business. The IT platform was supposed to be an inflection point for State Street because it enabled straight-through processing of data, provided real-time information on the cloud, reduced data-migration challenges, and expedited onboarding of new clients. This all sounded highly appealing. But having learned from my early mistake in the high-tech petrochemical sector, I asked whether the technology was proprietary or available to anybody. I learned that the technology was indeed state-of-the-art, but it was procured from a third-party vendor (IBM), which meant it was not unique, and anyone could buy or implement something similar if they chose to.
I therefore passed on owning the stock because I concluded that the new IT platform would indeed help with all the things State Street had described, but it would merely serve to reduce a competitive disadvantage, not secure a competitive edge.
Why? Because competitors like Northern Trust had their own proprietary IT platforms that already offered all the benefits that State Street was trying to secure with its new one. State Street had grown through acquisitions, and each acquired company had come with its own distinct IT system, creating a highly disparate infrastructure that needed an extensive revamp. This is why they needed to overhaul their IT platform at great expense while Northern Trust did not.
My initial misdiagnosis could have proven costly, but thankfully I course-corrected by asking the right questions, to ensure my final assessment was more on target. Several years have passed since the new IT platform was implemented at State Street. It has not resulted in any material market-share gains or conquest wins from competitors. Like its business, the stock has not had much traction either.
On the other hand, Northern Trust’s proprietary IT platform was and remains both robust and versatile. Because it is more flexible, it can offer greater customization and bespoke services in its core asset servicing business, which lead to higher customer satisfaction. This in turn enables Northern Trust to charge a premium price and enjoy better margins.
This is yet another instance of where the facts were true, but the initial, conventional inference drawn from them was false. Not all investments or improvements, however transformational, create business opportunity. The new IT platform was a definite improvement over the old one, but it did not help State Street move the needle in winning new clients or growing revenues; it primarily helped to retain existing ones and lower the cost of servicing them. This underscores the importance of distinguishing high tech from proprietary tech. They are not the same.
Buyer Beware: Knowing Quality for What It Is
A final word on understanding quality: It is bad enough to fall for low-quality companies that are masquerading as high quality, but it is practically a crime to fall for low quality that is obviously low quality. I’m talking about companies with no competitive advantages or compelling customer-value propositions, who engage in poor corporate governance; have weak balance sheets, internal controls, or oversight; don’t make enough money to cover the cost or risk of being in business; or have management teams who focus on short-term results at the expense of long-term value creation for customers and shareholders.
We are all familiar with the fraud perpetrated by Enron and WorldCom and the large losses inflicted on unsuspecting investors. Management teams such as those at Lehman Brothers, who focused on managing earnings instead of capital, blew up in the bonfire of their own vanities by taking on more risk than was prudent and exposed their employees and shareholders to both losses and humiliation.
What is noteworthy about these examples is not that their game was finally up, but that they could hide it for so long despite being audited by marquee accounting firms and being subject to stiff penalties under various regulations. As Warren Buffett points out, it is only when the tide goes out that you find out who has been swimming naked.
But the non-consensus investor understands that the key is to know who is swimming naked before the tide goes out, not after, because it is you who will end up losing money, not the swimmers.
Worse yet, some companies engage in fraud or accounting shenanigans that elude even regulators or auditors, let alone investors. This is truly a call for “buyer beware.” Low-quality companies are more likely to resort to accounting chicanery to inflate their reported earnings. But no matter how clever the companies pretend to be, they can obfuscate reality for only so long. And deploying the research skills described in this chapter can help you avoid them. Here is one more real-world anecdote of how to question quality—or the lack of it.
In 2006, while researching QBE Insurance in Australia, I wondered how they had managed to report terrific earnings growth for several years when the underlying industry backdrop did not call for such performance. I could not understand the “why,” so I walked away from a “what” that appeared too good to be true. It turned out to be a prescient move that spared me major losses. The stock plunged 65 percent, from a peak of A$35 in September 2007 to about A$10 through December 2018 (figure 7.4). It turns out there was no good reason for the company to have “made” those kinds of earnings. For several years thereafter, the company issued a series of profit warnings revealing that they had under-reserved for their liabilities (by implication, overstating past earnings and book values). A once-revered management team fell from grace and was booted out by the board, while investors voiced their disdain by dumping the shares. This is the power of understanding why as opposed to merely what.
Quality Does Not Come with a Label, but It Does Have a Definition
To sum up, then, when it comes to investing, quality is not black or white but has many shades of gray. Neither businesses nor their stocks come marked with quality labels (unlike bonds, which at least have credit ratings). To understand quality holistically and correctly, you need variant perceptions and unconventional frameworks that go beyond the typical clichés and checklists.
In assessing quality, you must be vigilant about circular logic, in which you confuse cause and effect or conflate numbers with the narrative. As we have seen, often a business can appear successful because of a favorable trend, with a rising tide lifting all boats, or a competitive advantage that proves fleeting or fickle. The symptoms of success do not explain the source of success—or its sustainability. It is crucial to understand that sustainability, because earnings power without staying power can be a recipe for losing money. In markets, low quality often masquerades as high quality, and that is among the worst possible investment traps you can fall into.
Although quality does not come with a label, I will take a stab at providing a working definition. A genuinely high-quality business is one that offers exclusive and enduring value propositions to consumers and generates a fair return to justify both the costs and risks of lawfully engaging and reinvesting in that business.
In this chapter, we learned how to avoid the entrapment of mistaking low quality for high quality. In the next chapter, we will learn about the opposite—how to identify a high-quality company, ideally one that is mistaken for low quality. With those mispriced winners, you improve your chances of scoring upset victories and generating higher returns with lower risk.
Top Takeaways
1. What causes people to lose money unexpectedly and unwittingly? The answer is quality—or, more specifically, a misconception of quality.
2. Conventional thinking not only fails to diagnose quality, but often leads you to misdiagnose it, giving you the market equivalent of a false positive or a false negative test result.
3. Reset your reflexive inferences and examine the counterfactual. Brands, pricing power, leading market share, etc. are symptoms of quality, not sources.
4. Quality is a mosaic, not a metric; a capability, not a criterion; a latticework, not a label. It is not black or white but has many shades of gray. To find it, you need variant perceptions and holistic frameworks that go beyond the typical clichés and checklists.
5. A genuinely high-quality business is one that offers exclusive and enduring value propositions to consumers and generates a fair return to justify both the costs and risks of lawfully engaging and reinvesting in that business.
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1. The Five Forces framework was created by Harvard Business School professor Michael Porter to analyze an industry’s attractiveness and potential profitability. Since its publication in his book Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Simon and Schuster, 1980), it has become one of the most popular and highly regarded business strategy tools.
2. To make this even trickier, today social media and digital marketing are leveling the playing field between the haves and have-nots. Even small budgets go a long way in an online and direct-to-consumer world.