The six good things that happen to great businesses

Even when you're finding value elsewhere, high quality businesses should be the foundation of your portfolio.

Even when you're finding value elsewhere, high quality businesses should be the foundation of your portfolio. You'll pay a little more for them but they're usually worth it because good things happen to great businesses in six different ways.

1. Great businesses foster solid reputations

A good reputation takes time to nurture but is easily tarnished (just ask Commonwealth Bank). Whilst a 'good name' seems an intangible quality, it offers very real benefits. Reputation open doors. Companies are better able to raise equity when they're proven performers and lenders are more willing to extend debt finance.

An excellent reputation also attracts high-calibre staff. Companies like Perpetual, Platinum Asset Management and Macquarie Group attract bright sparks because they'll have the opportunity to work with other high performers.

2. Great businesses maintain strong balance sheets

Maintaining a conservative balance sheet helps cushion industry downturns. In 2007, only months before the global financial crisis took hold, Westfield Group raised $3bn in equity, Australia's second-largest capital raising at the time. This decision spared securityholders the pain inflicted upon the rest of the property trust sector in 2008.

Net cash of more than US$500m is one of the reasons we've recommended sleep apnea treatment company ResMed. It provides flexibility to cope with changing industry conditions or to make a game-changing acquisition.

3. Great businesses benefit from 'multiple arbitrage'

Sensible acquisitions play a role in the success of many great companies. Those on higher earnings multiples can be beneficiaries of 'multiple arbitrage'.

This occurs when earnings are acquired at a lower multiple than the acquirer's shares and the market is willing to rerate the acquired earnings to the higher multiple. Aristocrat Leisure's acquisition of Video Gaming Technologies is a case where management apparently expects a market rerating, as indicated by recent director buying. The company has almost doubled its earnings but is paying less than half its own multiple.

4. Great businesses make 'synergistic' acquisitions

When it comes to acquisitions, two plus two sometimes equals five. Dominant companies that wish to avoid scrutiny from the ACCC can sometimes find value in adjacent businesses.

Woolworths, for example, acquired mail-order wine business Cellarmasters in 2011. Cellarmasters owned a wine production facility, which fitted well with Woolworths' plans to offer more private label wines. Integrating Cellarmasters' distribution capability also allowed Woolworths to fast-track home delivery for brands such as Dan Murphy's.

More recently, Carsales.com has bought stakes in Stratton Finance and iCar Asia. Access to capital and management skill as well as cross-selling opportunities means these businesses are more likely to thrive together than separately.

5. Great businesses take advantage of crises

When Bankwest and St George Bank had trouble securing funding during the GFC the two strongest banks – Commonwealth Bank and Westpac – were able to acquire them.

National Australia Bank, by contrast, was beset with its own crisis-related problems. Having blown up $830m on collaterised debt obligations that same year, it was never likely to be one of the Australian Prudential Regulation Authority's preferred buyers. A crisis might be a terrible thing to waste, but National Australia did just that in 2008.

6. Great businesses are 'buyers of choice'

Owners of private businesses often see them as their 'children'. They've built them from the ground up and almost regard staff as family. So when they sell for succession or portfolio diversification purposes, they want their baby to be looked after, perhaps sacrificing monetary reward for the right buyer.

Pathology provider Sonic Healthcare built its US expansion on just such a strategy. Its doctor-centric, medicine-focused approach won over American pathology lab owners who had held off selling to the industry's largest – and most 'corporate' – players.

Successful companies prove themselves adept at creating shareholder value while weaker competitors keep finding new ways to destroy it. Of course, high quality rarely comes cheap. Expect to pay a higher than average price-earnings ratio (PER) for a great business, even when it's out of favour.

But superior management, a solid reputation, a strong balance sheet and acquisition-readiness count for a lot. If they only generate a few extra per cent a year, you'll soon see a big difference in your returns.

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