[00:02:55] Shawn O’Malley: Finding quality companies has consumed investors’ attention for decades with no shortage of books on the topic like In Search of Excellence by Thomas Peters, Competitive Advantage by Michael Porter, Built to Last by Jim Collins, and Quality Investing by Lawrence Cunningham. So what is quality? The short answer is that it’s subjective.

[00:03:15] Shawn O’Malley: Every investor probably has their own definition of quality, but there’s certainly plenty of overlap. In general, you might think of quality businesses as those with wide competitive moats that dominate their industry. As a result, they either grow at above average rates for extended periods or are cash cows.

[00:03:32] Shawn O’Malley: Robert Hum at BlackRock puts it like this, quote, quality investing targets companies with a consistent track record of strong earnings and stable balance sheets. It has been around for decades and is supported by economic theory and empirical data. And it may use a combination of metrics such as profitability, earning stability, and low leverage to identify firms with strong earnings and stable balance sheets.

[00:03:55] Shawn O’Malley: He adds to that by saying, quote, If two companies have similar relative prices, but one has higher quality earnings, the company with higher quality earnings must have a higher expected return. This is a key difference between quality and value investors, who may also be looking to get more for their money, but typically concentrate primarily on the price of the company’s stock.

[00:04:17] Shawn O’Malley: Peter Slagers of Compounding Quality has his own outline of what it means to be a quality focused investor. As he puts it, Quality investing is one of the only investment methods where you can use a buy and hold strategy. With value investing, the idea is to buy stocks that are undervalued relative to their intrinsic value.

[00:04:35] Shawn O’Malley: So when a company is no longer undervalued in theory, you should move on to the next undervalued investment. This is essentially how Warren Buffett started his career. And with the help of Charlie Munger, he evolved toward a style that more closely resembles what you might call quality investing, where the focus is on finding great companies at fair prices to own for a lifetime.

[00:04:55] Shawn O’Malley: Quality investors look for compounders. That is, companies that can compound their returns and market meeting rates for many years. Microsoft is a great example with a compounded annual growth rate of roughly 26 percent per year since 1986. As investor Terry Smith frames it more simply, buy good companies, don’t overpay, and then do nothing.

[00:05:17] Shawn O’Malley: Quality investors do not typically look for the next big thing. Their focus is on finding companies that have already won, companies with a clear lead in their niche, strong pricing power, and a track record of outperformance. Some great examples from Peter Slager’s article on quality investing are S& P Global and Moody’s, two companies that control the credit rating business and are essential to global debt markets.

[00:05:41] Shawn O’Malley: For public companies to issue debt, they need ratings from credit rating agencies that provide information to investors about the financial health of the issuer and the specific characteristics of the bonds they’re looking to sell. They can charge companies hundreds of thousands of dollars for a single rating, and they’ve maintained their status as industry leaders for over five decades. That is quality.

[00:06:03] Shawn O’Malley: Another indicator of a quality business, according to Slagers, is high management integrity. He writes, quote, You want to invest in companies with high management integrity. Management’s interests should be aligned with you as an investor. Having skin in the game is very powerful. You want the people who run the company to be right there with you as shareholders.

[00:06:23] Shawn O’Malley: Otherwise, there’s a disconnect. What is in management’s best interest may not be exactly in your best interest as a shareholder. It is no secret that family owned businesses, which are the pinnacle of having skin in the game, usually perform better than non-family businesses. In a 2020 paper, Credit Suisse found that family companies outperformed nonfamily companies by 3.6 percent per year over the past 15 years.

[00:06:48] Shawn O’Malley: For the study, they reviewed a database of 1000 publicly traded family or founder led companies. Credit Suisse found that family owned businesses tend to have longer time horizons, deliver more stable and superior returns, and ultimately are more likely to drive significant excess returns for shareholders.

[00:07:07] Shawn O’Malley: In his book, Quality Investing, Owning the Best Companies for the Long Term, Lawrence Cunningham defines quality as companies with strong, predictable cash generation, sustainably high returns on capital, and attractive growth opportunities. He also identifies specific patterns to look for in high quality companies.

[00:07:24] Shawn O’Malley: These patterns include acting like a toll road, similar to how S&P Global operates, where, as I mentioned, companies need to get a credit rating to access debt financing, to low priced leadership like Costco, reliable recurring revenue like Netflix, Brand recognition like Coca Cola, pricing power like Apple, and so on.

[00:07:44] Shawn O’Malley: He finds, though, that the building blocks for these companies, even with different patterns for their success, are the same. Arguably, the most important building block is effective capital allocation, which can be evaluated by looking at a company’s return on invested capital over time, and its decisions on what to do with excess cash.

[00:08:03] Shawn O’Malley: The best compounders can earn 15 percent or higher returns on capital over time. Other such building blocks are having multiple sources of growth, good management, particularly management with a stake in the business, industry structures with low competition where a few firms dominate, satisfied customers, since having unhappy customers will eventually bleed through into a company’s financial results, even if it operates as an oligopoly.

[00:08:28] Shawn O’Malley: And lastly, companies with competitive advantages, meaning they not only earn above average rates of return, but are able to actively protect those above average returns from being consumed by competitors. To better understand those building blocks, and whether a prospective investment is truly a quality company, Cunningham suggests that you try and assess the quality of its products and services.

[00:08:48] Shawn O’Malley: You might measure brand strength by researching its customer satisfaction and loyalty, what types of reviews do their products get, how likely are customers to recommend them. On top of that, Cunningham finds that the best compounders are companies that don’t just have success in a single region but have expanded into a global market for their offerings, and even better if they’ve embraced innovation by investing heavily in research and development to help them gain new market share.

[00:09:14] Shawn O’Malley: Such quality companies also tend to have products or services that are very difficult to replicate. Building an aircraft to compete with Boeing, despite all the issues Boeing has had in recent years, is still incredibly expensive and difficult, which is why competition isn’t exactly pouring into that market.

[00:09:31] Shawn O’Malley: It’s the same with video games. Franchises like Call of Duty and Madden have dominated for decades, and to build a superior first person shooter or NFL football game while spending enough on marketing to pull loyal players from those games is no easy feat. The development and customer acquisition costs are both very high in those cases.

[00:09:49] Shawn O’Malley: These all boil down to a quality company’s pricing power. A company’s products or services yielding happy customers that are hard to replicate should also have tremendous pricing power, meaning they can significantly raise prices without seeing an offsetting drop off in sales volumes. Customers are more willing to absorb higher prices from high quality companies.

[00:10:09] Shawn O’Malley: During the pandemic, we really saw this in action. With supply chain snarled and labor shortages, companies saw mushrooming input costs. Just to maintain their same profit margins, they had to raise prices by 5, 10, or 20 percent in some cases. Others had to accept that they would be the ones to absorb those higher prices because it couldn’t pass them on to customers, leaving them with narrower margins.

[00:10:32] Shawn O’Malley: Meanwhile, some of the highest quality companies saw an opportunity to raise prices in excess of their rise in input costs, raising their profit margins. Chipotle is a great example of the type of pricing power quality companies can have. America’s favorite Mexican grill has raised menu prices six times since 2021, and it has raised prices even more in California, specifically thanks to new laws driving higher worker wages there.

[00:10:57] Shawn O’Malley: As Heather Hadden of the Wall Street Journal puts it, Quote, many Chipotle customers, though, are still willing to pay. In the fourth quarter of last year, Chipotle’s same store sales grew 8. 4%, and the company reported better than expected earnings for four consecutive quarters. It remains one of the fastest growing restaurant chains, with plans to build around 300 new locations this year.

[00:11:20] Shawn O’Malley: Prices have risen considerably, and yet that’s not really hurting Chipotle’s top or bottom lines. Chipotle’s brand officer credits that to most of their clients being millennials and Gen Z, who prioritize overall wellness over just price. Customization options, food quality, and convenience all help customers rationalize the higher prices.

[00:11:40] Shawn O’Malley: When it comes to a quality company like Chipotle with industry leading pricing power, the types of customers it has set the stage for that pricing power. Chipotle’s customer base broadly has the income to absorb price hikes. The average Chipotle customer is 20 percent more likely than the average US consumer to earn over 125, 000 a year.

[00:11:59] Shawn O’Malley: Meanwhile, Chipotle’s gross margins have expanded to 40. 9 percent from 34. 1 percent in December 2019, and its operating and net profit margins have doubled. That is a masterclass on pricing power, using economic disruptions like the pandemic as cover to boost margins. To be clear, not all companies can get away with this, and to me, that is one of the biggest differentiating factors when it comes to quality.

[00:12:23] Shawn O’Malley: And you can imagine that with a different customer base, like a lower quality restaurant, Chipotle wouldn’t have nearly the same pricing power. Now I want to look more deeply at how some other of the best quality investors think about finding outstanding businesses. With over 50 years of experience in the investment business, Chuck Akre is as well regarded as any quality investor out there.

[00:12:45] Shawn O’Malley: He operates from the quaint little town of Middleburg, Virginia, right in the middle of horse country, about an hour outside of Washington, DC. It’s a place where you might expect to go for a picturesque brunch or to watch a polo match. It is not, however, the sort of place you’d expect one of the greatest living investors to manage 14 billion of client funds from.

[00:13:05] Shawn O’Malley: Yet, right in the heart of downtown Middleburg is exactly where Akre finds perspective, quiet, and focus. His inspiration, unsurprisingly, comes from Warren Buffett and Berkshire Hathaway, which he has invested in since 1977, but also Thomas Phelps and his book 101 in the Stock Market. Acre coined the term compounding machines for companies that could compound returns for shareholders at the highest rates for the longest time with the least amount of risk of permanent capital loss.

[00:13:33] Shawn O’Malley: He said that his firm spends nearly every waking hour trying to identify such companies. He elaborates by saying, quote, compounding our capital is what we’re after. Striving for sustained uninterrupted compounding over long periods of time is smart investing. And that’s precisely our goal. Many people think of us as a value investor and others ask whether we are value or growth investors.

[00:13:55] Shawn O’Malley: We’ve started to say we’re neither. We are a compounding investor. Uninterrupted compounding is, in a nutshell, exactly what quality investing is all about. It’s not value or growth, or large cap or small cap, it’s something distinct. Acre is also famous for his metaphorical three legged stool approach to stock investing.

[00:14:14] Shawn O’Malley: Each leg is crucial to keeping the stool table balanced. Without one, the whole thing falls over. The three legs of the stool are finding extraordinary businesses run by talented leaders with compelling opportunities to reinvest money back into the business. He adds, quote, our focus remains entirely on the long term prospects of the businesses we own.

[00:14:34] Shawn O’Malley: Our simple view is that we will be successful if the businesses we own are successful, and if we do not overpay when buying shares of these businesses. For the first leg with quality businesses, Akre looks for companies with special edges that are hard to copy, those that are uniquely and sustainably better than their peers.

[00:14:51] Shawn O’Malley: Leg number one was very much inspired by his experience with investing early in Berkshire Where he realized that the best way to see whether a company was creating shareholder value was by looking at how it grew book value per share. Beyond that, Akre noticed that the long term returns of stock market indexes roughly followed the returns on capital generated by index constituent companies.

[00:15:12] Shawn O’Malley: He says the following. I look at it this way. The average annual total return from equities over long periods of time has been around 10%. When you clean up the accounting, the real return on equity of American businesses averages in the low teens. The point is that as the day to day noise and fluctuations and stock returns fade away, what’s left is the company’s ongoing returns on capital, which drive the returns it generates for shareholders.

[00:15:36] Shawn O’Malley: It’s one of those things that seems so obvious when said aloud, but it’s still worth repeating over the long term. It’s really not possible for a stock’s returns to be much better than its underlying business. If a company earns 8% returns on capital over 40 years, its shareholder returns are probably going to be just about 8%.

[00:15:54] Shawn O’Malley: As Charlie Munger frames it. If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. So the trick is getting into better businesses. Acre argues that all investing, whether in bonds or venture capital, is ultimately about the rate of return.

[00:16:13] Shawn O’Malley: And his conclusion is that when it comes to stocks, a stock’s return will approximate its return on equity over time, which is one way to calculate return on capital. When he goes fishing for companies, he likes to fish in ponds where all the prospective investments earn, on average, around 20 percent returns on equity.

[00:16:30] Shawn O’Malley: He says, quote, we recognize that over long periods of time, the share prices of our holdings should grow at a pace driven by the economics of the underlying businesses. It’s not quite as simple as running a stock screen for companies earning a 20 percent return on equity though. Acre and his team want to identify the key qualitative factors underpinning those high returns and identify the essence of each business they investigate.

[00:16:54] Shawn O’Malley: For example, you might ask yourself, what is it about MasterCard that enables them to generate after tax profit margins of almost 40%? Understanding the source of a business’s strength may not always be obvious, but it is critical. These enduring advantages could stem from intellectual property, economies of scale, favorable regulations, high customer switching costs, or network effects.

[00:17:16] Shawn O’Malley: There must be some understandable reason a company can earn unusually high returns, and Acre wants to know why in each case. In that same vein, Acre has said that they’re always asking how wide and how long the runway is for those unusual returns. An important element is pricing power, which we’ve already talked about.

[00:17:35] Shawn O’Malley: Acre says, quote, Our favorite businesses will be those which exhibit real pricing power with their brands, which require modest amounts of capital to prosper, which are run by people with equal parts skill and integrity, and which have demonstrated an ability to reinvest virtually all the excess capital that the business generates.

[00:17:52] Shawn O’Malley: Interestingly, Acre actually doesn’t think of diversification as his primary way of reducing risk. Instead, he relies on the quality of the businesses themselves as the primary tool for risk management in his portfolio. With that comes a need for resilient companies, those that can weather each part of the economic cycle and have the financial resources to capitalize on downturns by acquiring assets at discounted prices or repurchasing their own shares at attractive prices.

[00:18:18] Shawn O’Malley: Leg two is talented management. In Akre’s words, you want to find management that is terrific in managing the business, and presumably they have demonstrated that by the time we get involved, we ask them, how do you measure your success at this company? And by what means we listen to what they have to say and make our own judgment.

[00:18:35] Shawn O’Malley: Sometimes you get answers such as, well, if the stock price goes up, sometimes you find CEOs with screens on their desk watching their stock price all day long. That’s not a characteristic we find particularly attractive. My quick judgment would be their eyes are on the wrong thing. Acre prefers managers who are demonstrated killers at business execution, with a history of having always acted in the best interest of shareholders.

[00:18:59] Shawn O’Malley: His colleague at Akre Capital Management adds, quote, a company’s shareholders are often anonymous to its managers. Do managers nonetheless feel an obligation to treat those shareholders fairly? A close reading of the proxy statement can be instructive. We look at both the size of the pay packages as well as the incentives that trigger cash and equity bonuses.

[00:19:18] Shawn O’Malley: We love to find managers that have skin in the game through outright ownership of common stock. That, of course, sounds great, but to actually learn about management in that way, Akre says his firm reads piles of shareholder letters. Proxy statements and biographies while frequently visiting corporate headquarters, manufacturing facilities, and retail locations to see the business in action and ask managers open ended questions about how they think.

[00:19:42] Shawn O’Malley: The third leg relates to the reinvestment opportunities available to a company. Currently great businesses may not have as many opportunities going forward as they did in the past. And even the best management cannot manifest opportunities out of nowhere. The reality is that reinvestment is another way to say capital allocation.

[00:20:00] Shawn O’Malley: And as anyone who has read The Outsiders or has listened to my recent episode on the book will know, a CEO’s job is really to be a capital allocator. Warren Buffett is known to make this point by highlighting that after 10 years on the job, the CEO of a company that retains 10 percent of its net worth each year will come to deploy more than 60 percent of all the capital at work in the business.

[00:20:22] Shawn O’Malley: At Akre Capital Management, they’ve concluded that reinvestment is the single most critical ingredient in a successful investment idea after having identified an outstanding business. This is where CEOs will end up creating or permanently destroying the most value. And the task is no easy one. CEOs face the burden of taking all the excess cash generated by a business and investing it in projects that can earn above average returns.

[00:20:48] Shawn O’Malley: Reinvestment is also fundamental to the compounding process. A company’s ability to earn earnings upon earnings is essentially the definition of compounding. And excellent reinvesting can actually turn a mediocre business into a compounding machine, as Warren Buffett has demonstrated by transforming Berkshire Hathaway from a fledgling textile manufacturer to a conglomerate worth almost 1 trillion.

[00:21:11] Shawn O’Malley: With the three legs of the stool intact, and the business purchased at a reasonable valuation. All that’s left is to hold for the long term. To that point on buying at a reasonable valuation, Acre says, quote, we will be very disciplined about the price we are willing to pay. As in the end of our rate of return will be determined not only by the quality of the businesses we choose to own, but importantly by the starting price as well.

[00:21:34] Shawn O’Malley: While Acre is looking five or 10 years ahead for the companies it owns, quarterly earnings misses often provide opportunities to pile into the stock or expand the position. Selling because of a single bad earnings report is too often a knee jerk reaction that ignores the rate of return a company can earn over time.

[00:21:52] Shawn O’Malley: There is some flexibility on price though with great companies. Quote, if you paid 20 times earnings for a business that was compounding the economic value per share in the mid-teens and have some level of confidence it is likely to do that for a reasonably long level of time, you’ll get to heaven doing that.

[00:22:08] Shawn O’Malley: So that’s the three legged stool approach to quality investing. For more on quality investing, I actually want to turn to someone who’s not exactly well known as a stock investor, but still has a lot to say on the topic. That is Jim Collins, author of Good to Great and Built to Last, among the best business books ever written from a man who has spent much of his life working with a small team to study the patterns that define successful businesses.

[00:22:33] Shawn O’Malley: What I like about Collins research and writing is that it fills in a lot of the qualitative blanks that come to mind when discussing quality investing. for listening. It’s easy to say that you should find great companies to own, but what does that actually look like? There’s a lot more nuance than just repeating cliches about wanting to invest in companies with strong moats or great business models or management that is aligned with shareholders.

[00:22:54] Shawn O’Malley: Collins book really helps to paint the scene for what makes quality companies stand out. To identify the timeless fundamentals that define quality companies, Jim Collins and his partner Jerry Porras in the 1990s embarked upon an intensive six year research project that led to the book Built to Last.

[00:23:11] Shawn O’Malley: They studied the founding, growth, and development of exceptional companies that have stood the test of time. Companies like Hewlett Packard, 3M, Motorola, Procter Gamble, Merck, Nordstrom, Sony, Disney, Marriott, and Walmart. I’ll mention that some of these companies may seem a bit less exceptional now than they might have in 1995.

[00:23:30] Shawn O’Malley: So try and think about the context of the time as we go through Collins takeaways. But the point remains that even 30 years later, they’re all still household names with billions of dollars in market capitalization. These visionary companies as Collins refers to them had both endurance with an average age of nearly 100 years and is sustained performance.

[00:23:50] Shawn O’Malley: For example, at the time of the study, their stock had performed 15 times better than the overall stock market since 1926. They also studied each visionary company in contrast with a comparison company that had roughly the same opportunities but didn’t turn out as well. Procter Gamble’s, for example, was Colgate Palmolive.

[00:24:09] Shawn O’Malley: While Collins calls these firms visionary companies, you could just as easily call them compounders. One of the more lasting insights from Collins research is his finding that companies should be more like clock builders, not time tellers. The way he explains the difference is by asking readers to imagine a remarkable person who could look at the sun or the stars and quickly know the exact time and date.

[00:24:29] Shawn O’Malley: The only thing more amazing than that would be building a clock that could tell the time in the same way long after they were dead or gone. The point being that having a single great idea or charismatic leader is akin to time telling, whereas building a company that can prosper beyond the tenure of any single leader or product life cycle is clock building.

[00:24:49] Shawn O’Malley: The company itself is the ultimate product for clock builders. Achieving that requires seeing products and market opportunities as vehicles for building a great company, not the other way around. In fact, only three of the 18 visionary companies Colin studied began life with a quote unquote, great idea.

[00:25:06] Shawn O’Malley: For 17 of the 18 pairs of companies in the study, the compounders were guided more by a core ideology, a purpose beyond just making money, than the comparison companies. He uses the word ideology because as he puts it, quote, we found an almost religious fervor in the visionary companies as they grew up that we didn’t see to the same degree in comparison companies.

[00:25:27] Shawn O’Malley: On top of that, his study of enduringly successful companies found that many had cult like cultures around their core ideologies, making them passionate about being the best in the world in some niche. Walt Disney, for example, created an entire language devoted to this, where workers weren’t just employees, but they were cast members, and customers were guests, while jobs were parts in the performance.

[00:25:49] Shawn O’Malley: If Disney feels like an outlier, consider that Collins found this to be true at a range of companies, including small ones. At the rock and asphalt business Granite Rock, employees were called Granite Rock people, and not just anyone could be a Granite Rock person. Granite Rock people uniformly had a deeply embedded care for quality, service, and fairness, and if that didn’t resonate for you, there was no place for you at Granite Rock.

[00:26:13] Shawn O’Malley: Another insight I found interesting from Collins is the emphasis on homegrown management among quality companies built to last. Through the 1, 700 years of combined corporate history that Collins combed over, there were only four cases among the enduringly successful companies they studied where they hired an outside chief executive.

[00:26:31] Shawn O’Malley: Whereas the comparison companies in the study were six times more likely to go outside for a CEO. As Collins puts it, our findings simply do not support the widely held belief that companies should hire outsiders to stimulate change in progress. The reason that Collins thinks this matters is that insiders preserve the organization’s core values, understanding them in their gut to a degree that outsiders typically cannot.

[00:26:53] Shawn O’Malley: At Motorola, for example, Bob Galvin spent years learning from his father, Paul Galvin, founder of Motorola, before becoming CEO. Bob Galvin then kept Motorola’s core ideology intact and simultaneously revolutionized the company. At the very moment he began that revolution, by moving the company out of television sets and into solid state electronics, integrated circuits, and cellular communications, Bob Galvin also began succession planning for the next generation of leadership, a full quarter of a century before he would pass the reins, to maintain a lineage of homegrown leaders to preserve Motorola’s core values.

[00:27:29] Shawn O’Malley: At great companies that Colin studied, like Sony, Walmart, Disney, Johnson Johnson, Marriott, and Ford, among others, the founding entrepreneurs served as CEOs for an average of 37 years, dispelling the notion that early founders aren’t equipped to manage companies as they scale. Even more interesting is that these successful founders, in the spirit of homegrown leadership, were succeeded by insiders who oversell the company for 24 years on average after them.

[00:27:56] Shawn O’Malley: That is an average of over 60 years of continuous leadership from just two different people among some of history’s best examples of quality companies. The quality companies that Colin studied also rallied around what he calls big, hairy, audacious goals, or BHAGs for short, which had driven the companies to continuously improve.

[00:28:16] Shawn O’Malley: In 1945, Walmart founder Sam Walton’s b hag was to turn his single store into the best, most profitable retailer in Arkansas within 5 years. As Wal Mart grew, new b hags would replace the old. A second way to stimulate the drive for progress is to create an environment that encourages people to experiment and learn.

[00:28:36] Shawn O’Malley: To try a lot of stuff and keep what works. 3M began life as a failed mine and could not pay its first president a salary for 11 years, yet it grew into one of the most innovative companies in history, eventually branching into more than 60, 000 new products. As Collins puts it, at any great compounder, quote, Continuous improvement is a way of life, not a management fad.

[00:28:59] Shawn O’Malley: The challenge is to build for the long term while doing well today. The balance, then, among great clock building compounders is to both preserve the company’s core and stimulate progress. They need a continuity of values while an open mind to change, whether that be in changing internal processes or experimenting with new products.

[00:29:19] Shawn O’Malley: Collins adds, quote, the truly great companies of the 21st century will change within the context of their core ideologies while also adhering to a few timeless fundamentals. Collins has a lot more to say about what enables companies to stand the test of time and continue compounding successfully or return to greatness after periods of mediocrity, but that covers what I wanted to focus on for now.

[00:29:41] Shawn O’Malley: The built to last study doesn’t perfectly overlap with say Chuck Akre’s definition of quality, but as I’ve said, there are a range of perspectives on what quality businesses look like, and I think Collins’s insights add another dimension to the conversation on quality investing. For yet another perspective on quality investing, I want to turn to Chris Mayer, who runs Woodlock House Family Capital and is the author of the book 100 Baggers.

[00:30:07] Shawn O’Malley: Mayer is a wealth of wisdom on quality investing and compounders, and he’s built a career around identifying them. Mayer’s book is excellent, as is his blog. I want to highlight a few of his many wonderful insights on standout companies that compound returns for shareholders for decades. In a March 2023 blog post, he discusses the concept of linearity with respect to compounders.

[00:30:29] Shawn O’Malley: That is, the best compounders have linear stock charts. If you zoom out on the company’s stock price over time, it goes up and to the right in a relatively straight line. That’s because they’re consistently profitable, reinvest their profits, and are not overly impacted by economic downturns. One such illustration of this is the 10 year chart for one of Mayer’s portfolio companies, Constellation Software, which has a remarkably smooth upward sloping stock chart, with a nearly 1, 900 percent return over the past decade, that’s 34.

[00:30:59] Shawn O’Malley: 9 percent compounded annual growth. Meanwhile, if you did the same thing with a more cyclical business like United States Steel Corporation, it’s 10 year stock chart has four distinct peaks, two major troughs, and a handful of smaller ups and downs. After all the ups and downs, it has just a 2. 8 percent compounded annual growth rate, meaning its growth is essentially only keeping up with inflation.

[00:31:22] Shawn O’Malley: That is not a good compounder. So Mayer talks about trying to reverse engineer the linearity of compounders like Constellation, and one of the key components, which Mayer learned about from reading the book The Intelligent Quality Investor, is that compounders tend to convert a high percentage of their earnings into free cash flow per share.

[00:31:39] Shawn O’Malley: Free cash flow, if you’re not familiar with it, measures profitability by excluding non-cash accounting expenses like depreciation and adjusting for working capital needs as well as capital expenditures. After those adjustments, free cash flows represent the amount of profits actually available to lenders and shareholders.

[00:31:57] Shawn O’Malley: Companies that do not convert as many earnings into free cash flow warrant skepticism because it can indicate that the company’s earnings are low quality. One simple example is to imagine a company that makes most of its sales on credit to customers who really cannot afford to pay them. For a time, sales and accounting earnings might look strong as these customers make purchases on credit, but if these sales made on credit never actually go through, you would see that reflected in lower free cash flows.

[00:32:23] Shawn O’Malley: The observation that Mayer is making is that compounders tend to convert larger amounts of net income into free cash flows by doing things like more efficiently managing their inventory, collecting cash sooner for sales generated on credit, and making optimal use of tax credits and deductions, among really a full list of similar things that could possibly be done to boost the cash flows coming in over profits on paper.

[00:32:46] Shawn O’Malley: Mayer makes another nuanced point about compounders and corporate culture. Investors often talk about corporate culture, but what does that mean? And what makes for a good corporate culture? To him, culture includes how a business deals with employees, customers, and suppliers, as well as how it compensates and incentivizes executives.

[00:33:05] Shawn O’Malley: Sometimes, as Mayer points out, you can find revealing clues about a company’s culture in its annual financial reports, also known as 10 Ks. And one such report for a compounder he owns, Brown and Brown, they write in their 10 K that over 20 percent of the company is owned by employees, and that 60 percent of employees own at least one share in the company.

[00:33:25] Shawn O’Malley: That is the definition of an ownership culture. As an outside shareholder, you can find comfort in knowing that more than half of the company’s employees are shareholders alongside you. They benefit in the same proportion as you do to advances in the stock. Mare cites this as one of the many possible indications of a good culture that’s compatible with compounders.

[00:33:45] Shawn O’Malley: Additionally, good cultures tend to have lower employee turnover. One of Mayer’s other portfolio holdings, Old Dominion Freight Lines, invests heavily in training programs that boost employee retention and has well below average turnover for the trucking industry. As you dig in and research companies to try and better understand their culture, management, and industry positioning, You can find lots of great hints like these that will help you read between the lines in assessing whether a company is likely to compound its returns at above average rates for years going forward.

[00:34:14] Shawn O’Malley: Whether you’re filtering out companies based on having an inadequate track record of generating returns for shareholders, for not having much pricing power or lasting moats to protect competitive advantages, for not being family or employee owned, having too much debt, Or for not having a good culture, you’ll quickly realize that the investable universe of companies before you shrinks down dramatically.

[00:34:35] Shawn O’Malley: There’s just not as many companies that meet the full checklist of quality as you’d think. Chris Mayer says that over time, he’s become even pickier as an investor, and his checklist has grown longer and longer. In his blog, Mayer writes, quote, I have a hard time finding 10 names I love. I exaggerate, but not much.

[00:34:53] Shawn O’Malley: I have 10 stocks in my portfolio now and I’d be hard pressed to name 10 more that I’d love to own at the right price. Pickiness is okay though. As a long term investor, you may need only a few great investments across a lifetime. Warren Buffett is known for saying, quote, I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches representing all the investments that you could make in a lifetime.

[00:35:20] Shawn O’Malley: In Buffett’s case, a few investments really do stand out like Coca-Cola. By 1994, Buffett had paid $1.3 billion for a steak and Coke that’s now worth $25 billion and pays Berkshire over $700 million a year in dividends as Buffett put it in his 2023 shareholder letter talking about winners and mistakes.

[00:35:41] Shawn O’Malley: He says. The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winters to work wonders. In another blog post called The Best Businesses to Own, Mayer reflects on how people often tell him that a stock is quote unquote expensive because it trades at some high multiple of earnings or cash flow, and his response is usually to ask, well, what is your time horizon?

[00:36:04] Shawn O’Malley: The point being that saying a stock is expensive today based on a multiple of its current earnings is far less informative than it would sound. If a company’s profits are set to triple over the next three years, and you were choosing not to invest based only on its valuation as a multiple of profits from the last 12 months, then you’d be using the wrong frame of reference.

[00:36:23] Shawn O’Malley: In this instance, the stock’s valuation looks expensive today relative to recent earnings because investors are piling in ahead of expectations that it will triple its profits in three years. From a quality investors perspective, it then becomes more of a question of how confident you feel that this future earnings growth will occur and whether you think investors are over or under paying for that growth.

[00:36:45] Shawn O’Malley: If this sounds familiar at all, it’s because there are always lots of examples of this in markets, but the easiest comparison to make today is probably with NVIDIA. At any point in the last year, NVIDIA’s valuations based on recent earnings have looked crazy. And you may still think it’s crazy based on projections of future earnings, but the company’s future prospects have grown hugely AI has built up, since the company is by far the dominant player in the market for designing computer chips that power AI systems.

[00:37:12] Shawn O’Malley: So when it comes to valuing NVIDIA, time horizon matters hugely, and the same is true for any quality company you’re evaluating. Mayer provides an additional way to think about time horizons and investing with a simple graphic. The graphic goes from left to right, showing the timeline progressing from quarter to quarter to 10 plus years, with the factors primarily driving investment results over those periods layered over.

[00:37:35] Shawn O’Malley: Over one quarter, what drives investment results the most is usually sentiment. Sticking with NVIDIA, as people get more bullish on AI, that’s probably going to drive NVIDIA’s price up over the following months. And if the outlook for AI adoption shifts, that sentiment is going to hurt NVIDIA’s stock.

[00:37:52] Shawn O’Malley: Changes in valuation multiples tend to drive investment results on a yearlong time horizon. For example, a company may go from trading at 15 times next year’s estimated earnings to 12 times. Over 2 5 years, the broader economic cycle and industry trends will typically be what shapes the company’s returns.

[00:38:10] Shawn O’Malley: And then on a 5 10 year basis, returns are driven by the company’s returns on invested capital. After 10 years, people and culture are what fundamentally determine returns, as we talked about with Jim Collins and companies that are built to last. Mirror’s takeaway is to focus primarily on the right side of the chart, specifically company’s ability to reinvest to generate high future returns in capital, as well as focusing on people and corporate culture.

[00:38:34] Shawn O’Malley: He says that he spends most of his time, quote, understanding the people and the culture, getting a handle on incentives and trying to figure out the reinvestment opportunities and the returns the company is likely to make on them. I spend almost no time thinking about things like sentiment change or building a thesis around a change in multiple.

[00:38:52] Shawn O’Malley: Over a decade of ownership, those things don’t matter much. He adds, quote, Price is important, but these items on the right are more important. If I don’t have those, I’m not interested even if the stock looks cheap. Besides, the importance of the price you paid is another thing that bleeds out over time.

[00:39:07] Shawn O’Malley: Unless you really overpay big time, if you are right on the quality, you’re going to do okay. If a stock is going to do 20x for you, then 30 percent more on the purchase price is not going to kill you. Even if you overpay, you can still do well if you size it right and give yourself room to buy more later, but you got to be right about the business.

[00:39:26] Shawn O’Malley: And that’s why the bulk of my focus and research is on the right side of that chart. In his quest to find compounders who can generate 100x returns, Mayer has landed on a framework he calls the twin engines of growth. In short, the twin engines are underlying earnings growth and a higher multiple on those earnings in the valuation.

[00:39:44] Shawn O’Malley: In other words, you hope that not only will your quality stock compound returns, sales growth and free cash flow, or whatever the key metric is for that business, at double digit rates, but also that the multiple of sales or earnings that the stock trades at goes up at the same time, further juicing returns.

[00:39:59] Shawn O’Malley: If a company compounds returns at 20 percent per year, it will deliver a hundred X return in 25 years, assuming the stock’s price to earnings ratio remains the same. But if its valuation multiple rises from 15 times earnings to 30 times earnings by the end of that 25 years, as investors are willing to pay a premium for such a high quality company, Then your full return goes from 100 times your original investment to roughly 200 times.

[00:40:24] Shawn O’Malley: As great compound or stock prices thrust off into the atmosphere, rising valuation multiples accelerate the journey to eye popping returns. Let’s look at NVIDIA. In 2013, NVIDIA traded at 14 times earnings. In 2021, it traded at an average valuation of 110 times earnings. Meanwhile, NVIDIA’s compounded annual growth rate for sales has been about 34 percent over the past decade, according to FinChat.

[00:40:50] Shawn O’Malley: Incredible rates of sales and earnings compounding, which is Engine 1, paired with a huge rise in its earnings multiple, aka Engine 2. From 14 in 2013 to over 100 in 2021 and around 70 today, the stock has delivered a more than 300 times return in the last 10 years. The compounding of returns and higher multiple have worked together to deliver what is truly an incredible return for Nvidia shareholders.

[00:41:17] Shawn O’Malley: While quality companies can deliver excellent returns without the help of the second engine and rising multiples, it certainly helps to have that tailwind in your favor. And the wonderful thing about great compounders is that rising multiples tend to work in your favor or at least tend not to significantly work against you in the long term.

[00:41:35] Shawn O’Malley: That’s because with truly quality businesses, you will not be the only one to recognize it usually, and people will pay up to own a company as they realize just how good it is. So, as always, we’ve covered a lot today, from the building blocks and patterns of quality companies to the importance of pricing power, corporate culture, management with skin in the game, and reinvestment.

[00:41:55] Shawn O’Malley: We went through Peter Slager’s, Lawrence Cunningham’s, Chuck Acre’s, Jim Collins, and Chris Mayer’s different but similar frameworks for understanding and identifying the best of the best companies and markets over the long run. The biggest challenge with quality investing, I think, is to ensure that you’re not just selecting for companies that were the best of the best yesterday, but for those who will continue to be so tomorrow.

[00:42:16] Shawn O’Malley: That’s where the real art and skill is. Anyone can go on a stock screener and filter for above average rates of sales or earnings growth with modest amounts of debt and call that quality. But you’ll blindly be picking companies that have been the best quality, not necessarily those that are positioned to continue being the best quality.

[00:42:34] Shawn O’Malley: Looking at things like whether a company has more pricing power than its peers, whether customers go out of their way to recommend a company’s products, whether the company has a good corporate culture, as Chris Mayer would say, and whether it encourages its employees to buy its stock and be owners, whether it has a culture of breeding homegrown leadership, whether they have the sort of religious fervor for their mission that Jim Collins describes.

[00:42:55] Shawn O’Malley: That can all give you qualitative insights that build on the quantitative screens. You might run to identify sets of potential quality companies to own. I had a lot of fun diving into the art of quality investing in part because it resonates with me more than any other approach to investing that I’ve personally studied.

[00:43:11] Shawn O’Malley: It just makes a ton of sense to focus on the factors that determine outcomes for businesses the most and then look for companies with the best track records of success that are likely to continue that momentum going forward. I’ll leave you with the following on quality investing. The Nobel Prize winning economist Paul Samuelson tells us, quote, investing should be more like watching paint dry or watching grass grow.

[00:43:33] Shawn O’Malley: If you want excitement, take 800 and go to Las Vegas. That’s all for today, folks. And thanks for watching. I hope to see you again next week.

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