Good things happen to great businesses

There are many reasons why successful businesses continue to thrive while competitors wither away. So why shouldn’t you pay a little more?

Buying opportunities are like buses. There’s always another one along soon. But who wants a portfolio of buses that belch out the occasional dividend?

It’s much better to own the Mercedes-Benzs and BMWs of the stock market. Quality stocks that purr along effortlessly should be the foundation of your portfolio, even when you’re finding value elsewhere. You’ll pay a little more for higher-quality businesses of course but they’re usually worth it (within reason – see the box below).

There’s a reason you want quality stocks in your portfolio: good things happen to great businesses. But high-quality companies aren’t just lucky, they make their own luck. Let’s see how successful companies capitalise on their success.

Key Points

  • Good things happen to great businesses
  • You’ll usually pay a higher earnings multiple, even when they’re out of favour
  • It’s worth paying up because the market tends to underprice quality

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 provides some very real benefits.

For one thing, reputations open doors. Companies are better able to raise equity when they’re proven performers. And lenders are more willing to extend debt finance too.

Paying up for quality

Great businesses might cost a little more but don’t overdo it. We’re not suggesting you pay any price, just that you shouldn’t be afraid to pay a higher than average price-earnings ratio where you can identify sound reasons. Just don’t confuse quality businesses with pricey, flavour-of-the-year ‘growth’ stocks. Sticking with the car analogy: Mercedes and BMWs are fine, Ferraris are not.

For another, an excellent reputation attracts high-calibre staff. People usually want to be proud of the company they work for. And 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 management decision spared securityholders from the worst of the pain that was 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 too. It provides flexibility to cope with changing industry conditions or to make a game-changing acquisition should an opportunity present itself.

3. Great businesses benefit from ‘multiple arbitrage’

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

Multiple arbitrage 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. Table 1 shows a theoretical example of a company trading on an EV/EBITDA multiple of 12 times that pays 8 times for an acquisition.

Before acquisitionAcquirerTargetCombined
Table 1: Multiple arbitrage
Enterprise value12004001600
EBITDA10050150
EV/EBITDA multiple12.08.010.7
Twelve months after acquisition   
EBITDA  150
EV/EBITDA multiple (re-rated)  12.0
Enterprise value  1800
Increase (%)  12.5

Assuming the market later rerates the combined earnings to 12 times, the company has increased its total value by 12.5%. If the acquisition is partly debt-funded or if cost savings are possible, as is usual, the returns to shareholders multiply accordingly.

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

A solid reputation and a sound balance sheet are valuable assets in a crisis. When Bankwest and St George Bank had trouble securing funding during the global financial crisis, it was little surprise that 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. They might even sacrifice 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.

As you can see, there are excellent reasons to buy high-quality businesses. Successful companies usually 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.

Everyone loves a winner. Now you can buy them knowing that great businesses are great for your portfolio too.

Note: Our model Growth Portfolio holds shares in Aristocrat Leisure, Carsales.com, Macquarie Group, Perpetual, Platinum Asset Management, ResMed and Sonic Healthcare. Our model Income Portfolio holds shares in Carsales.com, Commonwealth Bank, Perpetual, Platinum Asset Management and ResMed.

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