Overview
A London-listed distributor that we’ve long admired, but only recently purchased for the fund, is a good case study. The business is very simple (which is itself a good sign).
Through their fleets of nicely logoed vans they supply - on time and in full - many of the products other businesses need but which they don’t sell on to their customers. To coffee shops they sell the paper cups but none of the coffee. For a hot dog stand, all the wrappings but none of the sausages.
Besides simplicity, the business has other attributes we look for when making an investment - the products they sell are essential to the running of a business (try selling coffee without cups), but are a very modest part of the total costs to a company - so their customers choose the distributor with quality and timely deliveries rather than the one with the lowest price. Alongside the customer loyalty flowing from good service, purchasing scale and high route density allow the distributor lower unit costs and a formidable barrier to entry. This makes for a wonderful business with superb returns on capital, despite skinny margins.
It sounds obvious - and it is - but for many companies this sort of steady, boring competence is sadly elusive. But it’s at the heart of what I look for in a company. Finding durable business models and the management teams who share our point of view on capital allocation become the two principal determinants of success in the long term.
How bad managers destroy value
The uncomfortable truth for most high-returns businesses of a certain size is that it’s hard to deploy all the capital that these high returns produce and preserve returns. What to do with the cash? Returning it to shareholders through dividends can feel dull for some managers, but rationing capital prioritises projects and preserves the returns of the business.
Part of the attraction of income investing is that a regular dividend commitment forces capital allocation discipline. Our distributor gets full marks on this front - having grown its dividend per share at 9.6 per cent compound annual growth (CAGR) since 1992. Very few management teams have shown such discipline for so long - much more exciting than paying a slightly larger dividend than last year, and a quick way to disperse capital, is to make acquisitions, and a big acquisition can soak up years of cash flow. Unfortunately, it’s also frequently where high returns go to die, as is demonstrated by the lamentable track record of large-scale M&A in creating value for shareholders.
There are exceptions, one of which is my distributor. Crucially, it doesn’t do big deals - it has bought more than 200 companies over the past 20 years. The model is to buy small, complementary businesses that do something similar and fold them into the main operation. They treat each acquired business well, so they maintain a reputation as both a desirable buyer and a desirable employer. As a result, they don’t get overcharged for each acquisition, and returns on capital including acquisition spend have remained attractive.
Many managers from the acquired businesses stay on and rise through the ranks, despite having made significant sums of money from the initial sale. They have a sense of pride in their business and want to continue the journey. In meetings with management, we have discussed the culture that facilitates this value-creating atmosphere: decentralisation, autonomy, trust, and clear incentives go a long way.
Investing is a complicated business but the keys to success can often be expressed simply: are these the kind of people you want to do business with? Would you want to own 100 per cent of the business and have these people in your life? Does management care about shareholders? If the answer is yes, the financial results often follow.
A near-perfect score
I have a checklist of 29 questions I ask about a company before I think about investing. Some are hard financial questions which require quantitative analysis but many of them of them are judgement calls. Questions like: how likely is it that sustainable earnings per share will be above 30 per cent in 5 years’ time? Is the business too operationally geared? Is it resilient in the face of changing macro factors?
Most require substantial research but the answer (or lack of ability to find an answer) helps guide the investment decision. If the answer to all or most of these questions is yes, then the odds of making a good investment are in our favour.
My distributor’s score? 28 out of 29.
