What makes Cochlear superior to BlueScope?

Cochlear demonstrated these six characteristics when we upgraded the stock to Buy in 2004. Look for them if you want to buy a wonderful business at a fair price.

Three weeks ago I penned a piece: Disappointed you missed this tenbagger? Don't be. The premise was that, while weak businesses can deliver excellent share price performance over a period, you're fighting the tide.

BlueScope Steel (ASX: BSL) was the company in question. The share price chart told the story.

Over the very long term, weak businesses invariably show their true colours. Unfortunately that colour is sometimes pitch black, as Arrium shareholders discovered when the steelmaker went into administration in 2016.

One of the companies contrasted in the piece was hearing implant manufacturer Cochlear (ASX: COH), which is a far superior business. So, by way of follow-up, let's return to 2004 to see what we can learn about why Cochlear has been a much better investment than BlueScope Steel.

You can see Cochlear's 20-year share price performance in the chart.

Of course I'm selecting a strong performer with the benefit of hindsight. But it's not theoretical – Intelligent Investor emphatically recommended Cochlear at around $20 in 2004, which is also when I purchased my own holding. The stock is now $178.

So what were some of Cochlear's characteristics that indicated business quality back in 2004?

High return on equity

Excellent businesses often generate high returns on the capital that shareholders have invested. In Cochlear's case its return on equity in 2004 was 25%. Businesses that can reinvest capital at high rates of return over time will end up growing earnings significantly. Cochlear's ability to reinvest means net profit has grown from $37m in 2004 to $224m by 2017. Cochlear's return on equity is now 41%.

Strong free cash flows

In 2004 Cochlear generated free cash flow of $36m – about the same as net profit – even after expensing all research and development. Typically high growth companies consume cash as they grow, so the fact free cash flow matched net profit was impressive.

Negligible debt

In 2004 Cochlear had borrowings of $26m and cash of $76m, which meant the company carried net cash of $50m on its balance sheet. While many companies will carry some debt, businesses that can operate without much debt are typically stronger and more durable businesses.

Self-funding of growth

As well as avoiding debt, it's important that companies that can fund their growth without raising equity. Cochlear has never tapped shareholders for capital since listing on the ASX in 1995, and shares on issue have risen only 15% over that 23-year period. An even better example is Reece, which has had the same number of (split-adjusted) shares on issue for two decades now (we upgraded Reece to Buy in 2016).

A 'high' price-earnings ratio

One of the greatest mistakes you can make is to look exclusively for stocks trading on low price-earnings ratios. At the time Cochlear was upgraded in 2004, the forecast price-earnings ratio was 21 despite the stock more than halving between 2001 and 2004.

Higher than average price-earnings ratios are not a valid reason to avoid a stock. If you're looking to buy quality businesses – which I'd argue you should be, given their long-term outperformance – then you'll almost certainly have to pay up. Quality rarely comes with a low multiple.

Excellent competitive position

While these five financial characteristics reflected Cochlear's strength, the reason for that strength was a qualitative factor – Cochlear's superior competitive position. Cochlear was by far and away the dominant manufacturer of cochlear hearing implants back in 2004, with more than 60% of the market. A business that dominates a niche is frequently a wonderful business.

Just as important as these six characteristics was what didn't matter – a decline in profit due to slow sales in the Americas. Cochlear's operating profit fell more than 40% in 2004. You should be hoping for profit downgrades at quality companies, as they will be your best source of buying opportunities.

Even wonderful businesses rarely grow in a straight line; some periods are weaker than others. If there's no bad news, you're less likely to be buying an underpriced stock.

Excellent businesses are few and far between; our Australia's 10 Best Businesses special report lists some names you might want to follow (including ‘The best of the rest' on page 23). Put them on your watchlist, then buy when the bad news hits.

Intelligent Investor is loading up the van and going on tour in April and May, with events on the NSW central and north coast, the QLD mid-north coast and in PerthAdelaideMelbourneSydney and Canberra. If you'd like to hear us talk about building a portfolio to weather any storm, book your spot here.

Disclosure: The author owns shares in Cochlear.

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