Ongoing brand advertising is needed to sustain awareness – is equivalent to maintenance Capex.
Portion aimed at influencing new generations of consumers – is equivalent to growth Capex.
A company's long-term track record of generating returns on its R&D outlay is often the best indicator of R&D efficiency.

3. Mergers and acquisitions

Characteristic of successful acquisitions.
1. Consolidation of fragmented industries
2. Buying a business that is already strong.
3. Leveraging network benefits
Remember, Much diversification is really diworsification.
Concerned when a company does multiple large acquisitions in short time.

4. Distributions to shareholders through dividends or share buybacks

Companies that clearly explain buyback and dividend policy in their disclosures.
Buybacks during economic downturn and Capex for growth during economic expansion

Working Capital:

Short term assets less short term liabilities. Should be less or negative. (software and insurance)
See historcial trend of Sales/WC
Companies that tie up very little extra working capital with incremental sales tend to be more attractive.

B. Return on Capital

Elements drive corporate cash return on investment:

1. Asset turns

Asset-light industries are attractive since they require less capital to be deployed in order to generate sales growth.

2. Profit margins

Zeroing in on gross margins, as opposed to bottom line net income, also helps distinguish competitive advantage from managerial ability
Sustained margin expansion also signals strength.
Big swings in operating margins can indicate that major cost components are outside of management’s control

3. Cash conversion

FCF return on capital
Operating Cash Flow return on capital

C. Multiple Sources of Growth

Best businesses to own are those in which end markets are growing rather than shrinking.

1. Gaining market share

When analyzing share gains, understanding the source is important.

2. Geographic expansion

Geographic expansion is one of the most challenging strategies for businesses to implement. Failed attempts can prove damaging to the original franchise.
But cracked the code in a handful of markets, it increases the odds that it can do so repeatedly. (Unilever)

3. Pricing, mix and volume

Pricing Power in brands whose high prices consumers take as ratification of quality or status (luxury items)
A more common source of growth comes through price/mix optimization.
Volume-based growth is the least valuable, since it entails increasing quantity at existing average unit prices.

4. Cyclical market growth

Cyclical growth poses analytical challenges: at some unpredictable point, a cyclical upswing reverses due to increased supply or reduced demand, at which point earnings and share prices tend to decline.

5. Structural end-market growth

e.g. disease prevention to urbanization and aging demographics, will grow.

D. Good Management

While good management can enhance results from quality companies, success or failure is not invariably a function of managerial action.

1. Disciplined stewards

Good managers have the patience and discipline to invest in organic growth and the willpower to resist the temptation of a dash for growth through ‘transformational’ (and often value-destructive) acquisitions. Excessively proud management teams indulging in undisciplined acquisition sprees rarely create value for investors.

2. Independent, long term, and tenacious

Good managers are independent-minded – acting according to prudent conviction despite prevailing winds or consensus sentiment.
Have long-term vision for a business and the tenacity to realize it.
Good managers are never satisfied. Energy is devoted to relentless identification and eradication of potential threats.

3. Out of the limelight - Low profile

Award-winning CEOs subsequently under-perform both relative to their prior performance and relative to a sample of non-winning CEOs

4. People matter

Good management recognizes that a top priority is developing and deploying people who will then help achieve an organization’s goals. Some corporate cultures are famous for producing great managers.

5. Candor

Effectively communicating to investors what is important and why.
Speaking in a straightforward professional manner rather than indulging in the elliptical spin politicians favor.

E. Industry Structure

1. Mini-monopolies

Mini-monopolies are about the real choices customers have at the time of decision rather than theoretical choices.
They usually arise from a product offering highly-valued customer benefits unavailable from rival goods.
That they exist more in customers’ minds than in economic models means they are sometimes less obvious, but their financial characteristics can be compelling.
e.g. Tobacco industries

2. Partial monopolies

Localized supremacy: where a company enjoys dominance in some regions, but not others.
Switching costs: This occurs when a customer buying one upfront product, such as a razor or a software package, gives the producer something close to a monopoly by purchasing additional products such as replacement razor cartridges or software upgrades.

3. Oligopolies

Companies tend to focus on fighting weaker competitors whilst leaving the stronger ones alone.
As a general rule, an oligopoly is preferable to a fragmented and volatile competitive landscape.
On top of that, we look for oligopolies where the industry structure has been relatively stable over time and where the logic persists for that stability being maintained.

4. Barriers to entry and rationality

Industries with low barriers to entry may still have high barriers to success and scale – just look at the restaurant industry.
By the law of large numbers, the sheer frequency of new entrants can eventually lead to one of them becoming successful and disruptive.
The big firms in an old industry are still owned by the families that founded them.
This is a good indication that the industry is not only enduring, but offers organic growth through retained earnings rather than dilutive new issuances of equity.
- e.g. Global confectionary industry
Rationality mechanisms
- Appreciate company policy to avoid discounts, as this is a sign of a genuinely long-term view as opposed to seeking artificial short-term boosts that risk long-term performance.
The advantage of share donators
- Look for share doners in industry.
- e.g. Ignored division of large companies, smaller companies which are unable to scale up as industry globalize or consolidates.
Security by obscurity
- Locks, lenses, ostomy products and bathroom fittings are relatively small and are not expecting hyper-growth

F. Customer Benefits

Intangible benefits

People have a favorite soda primarily because they enjoy the specific taste.
High-end handbags are not bought for utility but because of the image they project.
When buying chocolates for your partner on Valentine’s Day price is probably not among the most important factors.
Many people buy their favorite candy without checking price.
Products that go in the mouth or on the skin carry more intangible potential than those that sit on a table or go into a machine.
- e.g. cosmetics market has proven to be less discretionary than one might imagine. L'Oreal.

Assurance benefits

Assurance benefits are often based on reputation. A reputation of high quality or reliability is earned over time.
To compete with reputation is almost impossible, no matter how much money is staked on it.
Lower cost of product with greater risk of malfunctioning is not acceptable.
- e.g. Infant foods (Nestle), life jackets, fire alarms, helmets
SGS AND INTERTEK: WHEN IT PAYS TO BE SURE
- Testing companies with strong reputations can charge clients more, as producers buy a sign of confidence in product quality.
- But even for premium testing services, such assurance remains a negligible component of overall product costs.

Convenience benefits

Neighbors pay for proximity of grocery stores and restaurants. But, is vulnerable to competition, as it does nothing to prevent new rivals from moving in nearby.
e.g. when bank customers adopt automatic payroll deposits and bill payments or when telecommunications customers bundle cable, internet, and phone products.

Customer types

Retail customers
- Are more willing to splurge on items offering intangible benefits, particularly for smaller purchases.
Business customers
- Depend on size.
- Large companies will focus on cost savings and and pay less for intangible or convinience benefits.
- A machine that provides reliability and/or measurable production cost savings can be priced to reflect such benefits.

G. Competitive Advantage

Technology
- Important aspect is sustainability of technoloical advantage.
- e.g. Kodak and Polaroid
Network Effect
- Ironically, when network effects are too strong, they may backfire. An extremely efficient network can produce monopoly power and government intervention risk rises.
- e.g. auction site, internate search, social media, stock exchanges.
Distribution
- Large retailers know their size and value to manufacturers. Consequently, they will bargain firmly, pitting manufacturers against each other, even dropping those who won’t negotiate.
- In this case, having exceptionally strong product offerings that customers really want matters greatly.

Patterns

The desired outcome from quality companies is: strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities.
But the building blocks that enable companies to achieve these results vary widely, given the diversity of industries, business models, and competitive conditions.
There are no strict rules for quality investing
These patterns help companies to achieve quality status

A. Recurring Revenue:

Recurring revenues arise when an existing customer base buys additional services or products from a company
- e.g. jet engines, software, elevators
Equipment sales fluctuate in tandem with new construction, an inherently cyclical business. But service revenue continues steadily through economic downturns as building owners, occupants, and governments put a premium on safety and reliability.
This yields predictable value creation

Product upfront:

If a company struggles to generate new upfront sales at poor returns, related costs eat into the gains of ensuing recurring revenues.
so upfront sales + recurring service revenue is great combination to have.

The license model:

This purest form of recurring revenue model features predominently in software industry

The service model:

Many industrial companies enjoy good service revenue streams linked to products sold, but it is not always automatic.
Service models are strengthened when the risk of damage from product disruptions are regulated or mandated by law. e.g. Jet engines
Another source of strength for the service model arises when the breakdown of a piece of equipment is likely to cause economic disruptions for its owner. e.g. ship engines
Product longevity influences the value created by the service model of recurring revenue. The longer equipment remains in use, the longer it will require service and spare parts.

Subscriptions:

It is probably the least rewarding form. Becasue the recurring revenue resides in prospects for subscription renewals.
periodicals with genuinely differentiated content, to keep subscribers locked in.

Density and network benefits:

The greater the density, the lower the cost of recurring revenues and, therefore, the greater the profit.
The larger the service network, the faster it can meet customer needs.

Economic effects:

Subscription and service revenues tend to be billed in advance. Revenue therefore turns into cash more quickly than for companies that bill and collect only after goods are delivered or services rendered. Cash is always more valuable the earlier it is received.

The combination of potentially negative working capital, rapid cash flows, and low capital expenditure to support growth is rare in business – but is a common feature of the recurring revenue model.

B. Friendly Middlemen

The helping hand:

A dentist recommending an implant or even a brand of toothpaste.
Customers paying for the professional installation of manufactured products, for example by electrical or plumbing contractors.The craftsman’s goals are not necessarily aligned with those of the customer: besides safety and reliability – after all, he will be blamed for failure – and perhaps ease of installation, his focus will not be price, except to the extent of helping his own margin, which will point towards the pricier end.

LockIn:

The involvement of independent financial advisors or procurement consultants, for example, can complicate purchasing processes. These professionals sometimes function more as costly gatekeepers than friendly middlemen.
For complex products or those that are difficult to install or consume, professional training is a compelling lock-in strategy. If a third party provider is well trained in the installation of one company’s product, chances are that they will stick to it and recommend to customers.

C. Toll Roads:

Position of being a small, but vital, cog helps to create significant barriers to entry; often meaning that suppliers’ own competitive landscapes are oligopolistic and stable rather than broad-based and unpredictable.

Gold Standards:

The debt rating industry, where investors and regulators rely upon a handful of firms, dominated by Moody’s Investors Service and Standard & Poor’s Corporation, to rate bonds. They charge significant fees, paid by debt issuers, for ratings that simplify investor analysis.
Globalization and increasingly complex supply chains stoke demand for independent verification. As companies source from more counterparts around the world and have operations in multiple jurisdictions, the value of global gold standards increases; a trend that has benefited the testing companies, SGS, Intertek and Bureau Veritas, as noted in the earlier case study.
In finance, the proliferation of Microsoft’s Excel software

Magic Ingredients:

These are inputs bearing low cost but high value in production processes.
- e.g. enzymes, flavors and fragrances.
For yogurt makers, starter cultures and flavor additives represent a small fraction of total cost. But they can have a material impact on the taste and texture of the final yogurt, which ultimately determine sales.
In industrial processes, gases have a similar role: the cost of oxygen used in steel mills is trifling but if supply is disrupted, production ceases.

Industry structure and economics:

Toll-road companies are typically oligopolies, not monopolies.
Hence there are four global financial auditing firms, four industrial gas providers, three major credit rating agencies and three main testing companies. The lack of monopoly and substantial uniformity of products suggests that participants understand that they will be competing against each other for decades to come. That understanding leads to healthy competitive behavior rather than mutually destructive maneuvering.

D. Low-Price Plus

Low price stragtegy is rarely durable compettitive advantage, but combined with enhancing features, the pattern can be compelling. This i Low-Price Plus. e.g. IKEA, Inditex, Costco

Low-Price by name:

Cheap but resonable quality furniture - IKEA
Affordable Women's fashion - Zara, H&M
The success of low price brands depends on
- Degree of product differentiation
- Branding only works as long as operators can keep offering customers what they want, which is a fair and attractive deal.
- Scale is essential.
- The model depends on continuous and rapid response to shifting demand, meaning understanding changing consumer preferences, having control of the supply chain, managing inventory effectively, and deftness in distribution.

Low-cost squared:

Business achieves competitive advantages through several cost-saving small steps. When doing so translates into huge cumulative cost savings, the strategy punishes rivals and deters new entrants.
- Costco stores: Buildings are massive metal sheds in cheap suburban or rural locations. Lighting is cheap. Virtually all products sit on pallets – no shelving, stocking, or carting costs. There are no plastic bags. Stores only accept cash or Costco credit cards. While each saving may not account for much, in aggregate the cut is deep and lets the company do one thing and do it best: offer the lowest price.
RYANAIR: Started from London-Ireland flight, due to low fuel cost advantage, scaled into markets across Europe

E. Pricing Power

The Pricing Power is more theoretical than real.
Because, many companies that have some degree of pricing power prefer not to discuss it due to its close association with monopolies.
- HERMÈS: Premium luxury goods (leather, scarves, ties, men's and women's wear, perfume, watches, stationery, footwear)

Conditional pricing power:

e.g. An aircraft engine manufacturer may enjoy pricing power on its service business but this is conditional on its having closed a sale, where it may lack pricing power.

Pricing for value:

Computer software vendors add small features accompanied by substantial price increases.
Monsanto develop seed products that improve farm yields by 1-2% annually. Monsanto pursues a strategy of sharing the value upside with the farmer, raising prices each year to a level that means approximately one third of this benefit accrues to them, with the farmer getting the rest.

Downside of pricing power:

Price deflation.
- e.g. Hardware industry with substantial volume growth and significant innovation.

F. Brand Strength

Apple brand has its 'superfans', and there are life-long devotees of brands like Louis Vuitton, but we are not aware of similar appreciation groups for Air France or Delta Airlines – or Bank of America or HSBC. Differentiation and customer attachment allows for premium pricing and potentially gains in market share

Heritage Brand:

Ray-Ban Aviator sunglasses benefit from a tradition backed by movie stars and pilots over decades. Such legacies are impossible to replicate: no amount of capital can reproduce such a history.
Swiss chocolate sounds tastier than Finnish chocolate and leather goods from Italy or France are often perceived to be of higher quality.

Trust and consistency:

McDonald’s is built on a simple formula: inexpensive food of consistent quality delivered quickly in a clean environment.

The danger of newness:

The Nintendo case (newer rivals such as Microsoft Xbox and Sony PlayStation overtook it) illustrates how brands are more vulnerable when novelty and fast-changing technologies play a large role in the benefits it offers. This can also happen in fast-changing world of fashion.

Scale Advantage:

In sporting goods, Nike can attack rivals posing a threat in a given market by immediately increasing exposure, even hiring the best local athletes to endorse products.
Customers are unlikely to defect from a grocery store on the grounds that it did not carry a particular brand of toilet paper, but failure to carry Coca-Cola may well produce some defections.
Smaller brands typically have fewer distribution points compared to larger rivals, meaning higher costs per sale and fewer chances to connect with customers.

Using a powerful brand to drive growth:

Brand power can be enhanced through innovation and extensions. With creativity and advertising, strong existing brands can anchor expansion into new products and categories.
However, too many products can dilute the appeal.

Portfolio companies:

We believe that a portfolio of personal care products or luxury brands is generally superior to a portfolio of food brands.
On the downside, managing a portfolio of brands requires a wider skill set than handling one or a few brands. Juggling many brands, especially in multiple segments, risks obscuring corporate focus and stretching management too thin. Resource stewardship must be ramped up to assure their most effective deployment across various lines.

Longevity:

Brands that have retained preferred status for decades have something special. While this doesn't insulate them entirely from future disruptions, such brands clearly have an enduring appeal that should help them to survive.

G. Innovation Dominance

Companies with high gross margins, invest more in R&D, A&P, or distribution than their rivals and forge virtuous cycle of growth.

Innovation culture:

Facilitate volume growth and pricing power.
It is usually easier for companies to command higher prices and margins on new products versus old ones.
In many industries, companies must innovate simply to defend their position. If this comes alongside declining margins (as R&D expenses are not covered by incremental sales), a company is engaged in costly cannibalization, not value creation.
In consumer goods, the most common way to achieve switching is the trade-up to a more expensive version of an existing product. ‘Premiumization’ for products associated with social status or those conferring health advantages, where a higher price is often perceived to yield a greater benefit.
If consumers are more cost conscious, or products are defined primarily by taste benefits, volume gains are often a better target for innovation.
For corporate consumers, (often highly risk averse) incremental improvements are usually easier to sell than revolutionary innovations that require big changes to how the business operates or which create new, unknown risks.

R&D-led innovation:

Define fields mor- e precisely. e.g. Pharmaceutical is too broad, narrow down to oncology or diabetes care and find which company is having more share in R&D.
By comparison, companies that have delivered a big breakthrough may or may not repeat this success. Moreover, incremental innovation tends to sit better with customers. Annual price increases of 5% for corresponding improvements become routine; abrupt price increases by a company with no track record of improvements provoke critical customer scrutiny about the price-value mix.

H. Forward Integrators

The most successful forward integrators are powerful global brands
Weaker brands struggle to draw shoppers to stores or traffic to websites.

Strategic value:

In retail, clever merchandising can stimulate customers to trade up and explore new things, as they try on clothes or smell perfume.

Offense and defense:

Companies that control their own stores and infrastructure depend less on the kindness of strangers to promote the company's benefits.

Franchising:

Franchisees pay fees for the right to use a brand. The fee level is justified by the economic power of the brand.
Revenue-based franchise fee adds predictability to the franchisor's return
Need two characteristics:

Underlaying business should have powerful economics, such that third part can make attractive return even after paying a fee to the brand owner.
Company must have the infrastructure to support a franchise system and the financial firepower to support a brand with A&P

Physical and online presence

I. Market Share Gainers

By drawing customers from rivals, such growth can be isolated from overall market growth and hence less dependent on macroeconomic variables.
This can be possible based on scale, as large companies will have larger budgets for R&D & A&P.
If a company faces increase in cost, then raising prices at expense of market share is a rational decision.
But if compnay is low cost producer then, it should not increse price.
Short term market share gains can be negative in some cases, such as bank lending, where market share can be increased by simplly lowering credit standard.

J. Global Capabilities and Leadership

It is unsafe to assume that the most powerful domestic company will remain dominant when there are superior peers operating in the same industry abroad.
Companies ability to expand and successfully adapt business model abroad.

K. Corporate Culture

Cost consciousness for a low-cost provider,
Scientific curiosity for a research-driven company,
Team spirit in collaborative production businesses such as providing third-party certifications of credit quality or financial reporting.

Trustworthiness:

Can be seen by, how the company handles bad news.
Value companies that voluntarily confide their mistakes and discuss the lessons learned from them

Long term:

Short-term earnings goals are readily achieved by cost cutting, and revenue growth targets can be hit through an aggressive acquisition campaign.
Prefer companies which play the long game by allocating capital to organic capex, R&D and advertising in order to drive long-term growth.
Companies which influence incentive compensation plans not only for top management, but throughout the organization.

Execution:

Companies that are good at executing tend to be less ‘accident’-prone.
They do not suddenly announce big cost overruns on their latest information technology or recently discovered kinks in an acquisition made two years earlier.

Self-perpetuation:

Recruit with personalities fit the associated culture.
Cultures, as a result, tend to self-perpetuate. e.g.
Creative types are an asset for the design of haute couture, but are not the ideal choice to help build nuclear reactors.
A deep-rooted cost culture is more critical to a low-cost provider than for purveyors of premium brands.

Family ownership:

Distinction between family-owned and family-run can be important – research tends to confirm our hunch that corporate cultures of family-owned businesses often align them with the criteria of quality investing.

L. Cost to Replicate

Invert the analysis to access durability of a competitive advantage.
Clever marketing and deep pockets enable new entrants to develop a competitive brands of gin or vodka (White Spirits), it is challenging to do with cognac or whiskeys(Brown Spirits), because latter requires aging, entailing not merely creativity and resources but unusual patience (often over ten years).
For aircraft engine, where capital is rarely a barrier, but the proprietary technology generated by spending decades of R&D.
EXPERIAN compnay has credit history data dating back to 19th century.

Pitfalls

Companies might appear stronger than they are due to cyclical growth, the temporary tailwinds of fickle consumer trends, or technological leadership vulnerable to disruption.

A. Cyclicality:

Focus on whether the company's economic model depends on the customer's capital expenditure or operating costs.

For a company whose profits are dependent on capital expenditure, it is extremely difficult to predict results. Even a rough guess requires insight into both commodity pricing and how miners evaluate investing in new capacity at different price levels. A more reliable estimate would consider long-term demand trends for the given commodity.
For a company whose profits tie to customers' operating costs, cyclicality poses less risk of disruption and remains relatively predictable. Even during cyclical downturns when prices are low, most producers maintain existing facilities and even production levels while cutting capital expenditures.

When expansionary periods last longer than before, companies exposed to the cycle will look the most compelling. Their five-year and even ten-year track records can look so strong as to make it seem illogical to consider what occurred 20 years earlier.
When cyclical industries falter, many analysts portray it as a natural or even healthy adjustment period. They say it may be painful, but it will end. Yet when the cycle turns up, the talk is of permanent trends and why this upturn is different, and more durable.
For highly cyclical industries, it is when prospects look brightest that investors should be most wary.
Time can become investors enemy concerning cyclical companies.
The value of owning the highest quality company rises with cyclicality, as these companies tend to be better equipped to deal with it and capitalize on it.

B. Technological Innovation

When investing is whether a company's products will still exist in a similar and relevant form ten years hence.
People will want to travel safely down buildings even if they work for Amazon, and as long as people want to look good, they will buy cosmetics.
Scaling innovation risk:
- Small-scale innovation, like improved product packaging or safety, usually adds value and poses modest risk.
- Big innovation results in more victims than victors, despite what industry leaders might assert.
Fast-paced innovation:
- Industries with high innovation rates are especially unpredictable e.g. Nokia in mobile

C. Dependency

Governments:

Wary of businesses where governments play a large role in determining corporate fortunes.
Government industrial assistance or protection should be viewed as transient, no matter how noble or long-term the government’s intentions may seem.

Stakeholder concentration:

Strong customer relationships are wonderful but reliance on precious few creates concentration risk.
Concentration in any part of a company’s value chain harbors hidden risks that can degrade its economics.

New entrants:

Domestic companies already facing significant competition in foreign markets may find those rivals threatening them at home as well. Hence study competitive advantage in global context.

D. Shifting Customer Preferences

When customer preferences change, customer benefits that once provided a competitive advantage can quickly evaporate, threatening even the mightiest of companies.

Benefit switch:

In today's context, today companies in food industry grapple with increased interest in nutritional content rather than the historical focus on taste.
In retaling, historical competitive advantage of proximity is reduced by rising online shopping.
Try to consider them as part of durability of competitive advantage.

Fashion Risk:

Toy industry historically been fertile ground for fads to take root and flourish. Typically such fads are single products or brands whose appeal spikes in one year and then plummets within a few.

Good-enough goods:

The strategy's success depends on offering greater benefits compared to rival products. We refer to products that rivals push to challenge that advantage as good-enough goods.
e.g. Private label retailers, e.g. White label goods sold in Dmart, Future Consumer, Reliance. Linux as alternative to Windows.
Good-enough value propositions can be difficult to protect against. Niche products are typically better protected than large product categories because good-enough goods are likely to require scale to work.
We struggle to see how a good-enough handbag will ever be a credible threat to a branded luxury-goods handbag. Similarly, we doubt that many airlines (or their pilots) would want to fly aircraft with a good-enough engine rather than one with an impeccable record for safety and soundness.

Implementation

A. Challenges

Battling short-term thinking:

Long-term compounding versus short-term pressures
What counts are multi-year periods, not quarters
Over long term advantage often goes to the plodding and patient rather than the daring and fleet.
Transaction fees and taxes in short term.

Living with short term under performance:

Deeply cyclical sectors lacking strong steady returns on capital or with thin margins are anathema to quality investors. But share prices of such companies often benefit when markets trade certainty for hope. In these industries, small improvements in the macroeconomic environment frequently drive significant improvements in profitability. When markets favor such firms, a quality-focused portfolio will likely deliver comparatively weaker returns.
Quality companies have historically fared much better than the market amid economic upheaval.

Qualitative judgments in a data-driven world:

As it is easy to explain EPS and PE than to explain that a company is great, Analysts, managers, and directors generally use quantative analysis over quality.
Conquering prevailing preferences for 'hard' numerical data over subjective assessments of quality

Being dull in an exciting profession

Accepting that quality companies are not always the most exciting investments
Stock picking is not finding a company with hidden trunk full of gold.
Usually undervalued stock are hidden and rare, they require astute research or at least an elaborate new angle.
Quality companies don't have this pot of gold. They tend not to have product that revolutionize the world.
But they are very simple business, and they do what they have done consistently for decades.

Accepting that quality stocks will often appear to be expensive.

B. Mistakes when Buying

Top-down intrusion:

Don't do 'top-down' analytics by looking at the broader environment, considering the state of international trade, the rate of inflation, or the relative strengths of currencies, because when commodity prices fall or currencies reverse – it can be harder to stand by the thesis.
When top-down factors trump bottom-up analysis, it often leads to choosing companies and industries for the wrong reasons.

Next-Monday optimism:

Don't believe in same tune that good times are around the corner, assuring investors that problems are behind them and swearing on a new product launch or acquisition.

Overconfidence:

Any investment in a stock that depends on the outcome of external factors beyond a company's control is on shaky ground.
- e.g.
  - a pharmaceutical company on the assumption of forthcoming approval of a drug;
  - a gaming company on the belief that authorizing legislation will be enacted;
  - a mining company because iron ore prices are likely to rise.
The illusion of predictability also seems to recur in companies that are organizationally complex, such as industrial conglomerates or diversified financial institutions.

Debt:

Amid periods of economic expansion, the operating leverage enables growing revenue at lower cost, enabling cash flows that comfortably cover repayment of borrowed money. But in economic downturns, high operating leverage readily translates into rapidly deteriorating cash flows and difficulty meeting debt obligations.
When retailers grow rapidly during economic expansions, growth often includes adding stores using leased spaces. During such periods, it is easy to overlook that such leases are a source of leverage. When economic conditions contract, the lease rates remain the same while revenue and cash flows decline.
During economic expansion, market valuations tend to be high and it can be tempting to compromise on issues such as leverage. Such an environment breeds mistakes, few more dangerous than overlooking the downside and sources of debt.

C. Mistakes of Retention

Due to complacency (self-approval) and failure to appreciate when a once-great company is falling from grace.
Myopia(short-sighted), rationalization, and developing emotional attachment to investments.

Boiling Frog:

A material profit warning, even from a company in a relatively stable industry, can indicate that serious internal problems are brewing, suggesting a need to fully reevaluate the investment thesis.
Growth not materializing, Unexplained pressure on margins, more discussion of competitive pressures, or gradual increases in capital expenditure.
Each disappointment is small in isolation; management provides a good explanation for each and dismisses them as non-recurring. But a string of setbacks often signals a larger set of problems

Ignoring changes to the marketplace:

It is tempting to interpret adversity as transient – to see sagging growth as a blip rather than structural, or a new competitor as unthreatening to a company's core business.
Technological changes driving market alterations are often more serious than they initially seem, especially in consumer or retail channels.
e.g. The Yellow Pages companies from America to Europe went from virtual monopolies to business dinosaurs within a few years.
Scrutinize and question a company's ability to make the changes necessary to protect its business model.
Any company forecasting improvements several quarters into the future despite a choppy near term is conveying hope not facts.

Thesis creep and "yes, but" mistakes:

When you do top-down intrusion, two variations of yes, but seen:

"the market is on top of the issue now"
"the stock is cheap now."

If a company has highlighted a problem, the market knows about it; and its price-earnings multiple will have accordingly contracted.
If a position is maintained as a result of “yes, buts” it is probably a mistake.

Accounting red flags:

premature revenue recognition,
inflated gross margins,
improperly capitalized expenses,
depleting reserves,
manipulating cash flows
Accounts receivables growing faster than sales -> Indicates that the company might have extended payment terms to benefit sales growth or that the company is taking on increased customer payment risk.
Capitalizing a growing proportion of its R&D spending -> Meaning deferring the recognition of expenses from the current period to future periods.

The endowment effect:

The emotional connection amplifies with time, increasing susceptibility the longer a stock is owned. The endowment effect may manifest itself when an investor continues to own a stock despite a drumbeat of negative events revealing a deterioration of the company’s fundamental economic characteristics.
One strategy to combat this is to ask whether, with a fresh start, you would still buy the same company today.

D. Valuation and Market Pricing

A quality investing strategy, emphasizes quality first, and valuation second.

Limitations of traditional valuation approaches:

When investors rivet on value, there is a tendency to put too much weight on the result, to interpret what is clearly an estimate as hard fact, and thus to miss opportunities.
Putting quality ahead of valuation helps us to seize the long-term opportunity.

The insufficient valuation premium for quality

The risk of overpayment in case of quality investing is far less.
There are usually plenty of companies that trade on lower multiples and with seemingly higher growth rates.
Many investors might agree that some of the companies we have been illustrating are great companies. They just want them cheaper.
But the day seldom comes: if a company keeps delivering operationally, its relative valuation multiple rarely contracts.
Such day usually comes in the midst of the turmoil of a major market correction.
On a one-year view, nearly 80% of stock price moves are explained by changes in multiples,50 the driver of longer-term stock returns is earnings growth.
Companies that are consistently able to deploy cash at high incremental rates of return often exceed earnings expectations over the long term. So, while the valuation premiums of such companies may reflect solid expected operational performance, they often underestimate actual performance. Thus, stock prices tend to undervalue quality companies.

E. Investment Process and Mistake Reduction

A basic tenet of intellectual inquiry is to attack a subject from multiple angles in order to form a full picture of a target investment. This attitude was developed by Philip Fisher as the “scuttlebutt method” in his 1958 investment classic, Common Stocks and Uncommon Profits.

Mistake reduction:

Checklists can help focus rationality and confront the important questions about an investment. Given the complexities, no checklist can capture every nuance or draw attention to every risk. However, using them can facilitate adherence to the principles of quality investing
Attempting to recognize and combat biases:
- cognitive errors such as confirmation bias, hindsight bias, and outcome bias are rife in the investing world.
- Primary technique to combat bias is focus on process rather than outcome.

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