3 companies that fit the “quality” moniker

“Quality” is a label that gets slapped on lots of investments these days, and it can mean different things to different people. 

For Abrie Pretorius, portfolio manager in Ninety One’s quality investments team based in New York, a quality company has a long-term sustainable competitive advantage sourced from intangible assets.

“We think there are a handful of companies that can sustain their competitive advantages for far longer than what the market appreciates.

"These are typically businesses where the primary source of their competitive advantage comes from intangible assets. These are innovation-driven businesses with very strong R&D pipelines", notes Pretorius. 

He adds that when innovation is the source of competitive advantage, it is “really hard to replicate,” leading to sustainable return profiles.

Key attributes of quality businesses

Elaborating on the comments above, Pretorius identifies several distinguishing factors of quality businesses:

1. Demand creation through innovation: Innovative companies solve specific consumer or business problems, creating a self-sustaining demand cycle independent of broader economic trends.
2. Limited competition: The unique offerings of these businesses create high barriers to entry, minimising competition.
3. Cash flow and capital allocation: With lower capital needs, these companies generate substantial cash flow, enabling reinvestment in innovation and a continuous strengthening of competitive advantage.

Pretorius comments that the focus on investing in companies with these characteristics notably diverges from passive strategies, which base investments on historical data.

According to Pretorius, while passive and momentum-driven strategies may perform well in short-term timeframes (0-2 years), Ninety One’s approach shows its true potential over longer-term horizons (2-3 years+), where consistent compounding takes precedence.

Where Ninety One would not invest

Whilst I’m sure you can think of areas of the market that lend themselves more to innovation than others (think tech and healthcare), Pretorius notes that Ninety One is willing to buy companies anywhere in the marketplace.

“You can find these types of characteristics in a lot of different places in the market”, notes Pretorius, before adding that there are indeed some areas where you won’t.

Ninety One wouldn’t typically invest in businesses dependent on leverage or debt to fund their business model. This essentially rules out banks, which would generate low returns on capital without leverage.

Having said this, not all financials companies are blacklisted. 

“Certain financial assets, like stock exchanges or credit card providers - those are very, very good businesses”, adds Pretorius, given their predictable, high-margin business models.

Ninety One also typically avoids commodity-based and carbon-intensive sectors, namely commodities, utilities, and other highly cyclical industries where long-term revenue predictability is compromised by volatile prices or substantial carbon footprints. This aligns with the focus on companies that can compound returns predictably over time.

So, what areas does Ninety One like right now?

Over the 17 years that the strategy has been run, the portfolio has been most likely filled by consumer businesses, particularly consumer staples. Between 2010 and 2015, as much as 60% of the portfolio would have been in consumer staples.

Times have changed, however, and while consumer businesses still have a place in the portfolio, the percentage is “now less than 15%”, says Pretorius. Today, the biggest holdings by sector are financials ex-banks and tech names.

Just like in financials, not all tech companies are created equal. Ninety One's focus is on businesses in which the majority of revenues come from subscription revenue, which Pretorius says creates “very predictable businesses that can compound.”

Two companies that make the cut

To illustrate Ninety One’s approach, Pretorius nominates Visa (NYSE: V) and Microsoft (NASDAQ: MSFT) as high-conviction holdings.

These companies embody Ninety One’s ideal of “quality compounders” with robust business models and substantial barriers to entry.

• Visa: A classic example of a high-quality business says Pretorius. Visa’s position as a global payment processor allows it to capture value from ongoing digital payment trends while benefiting from stable revenue streams and high margins.
• Microsoft: The company’s structure and diverse offerings make it a compelling long-term investment, especially in the context of the growing generative AI market. Microsoft’s emphasis on subscription and annuity revenue models, as well as its monetisation strategy across different AI-related layers, allows it to capture ongoing growth within this innovative segment. Pretorius notes that Microsoft’s model contrasts with other large tech firms, which tend to rely on more transactional revenue.

An opportunity amid market optimism

Aside from the two names mentioned above, the portfolio includes resilient, growth-oriented companies trading at what Pretorius considers attractive valuations, especially given the broader market’s elevated price levels.

While the market remains “one standard deviation above long-term averages,” indicating an optimistic stance on growth, Pretorius believes “quality compounders” can continue outperforming due to intrinsic resilience and predictable cash flows.

Portfolio strategy: building a diversified starting lineup

Pretorius notes that in implementing the strategy, Ninety One doesn’t own the market. Instead, it picks a select group of companies for their possession of the characteristics noted above and their contribution to the overall portfolio.

Using a rugby analogy, Pretorius likens Ninety One’s 28-stock portfolio to a sports team.

“You need to have the optimal combination of offence and defence - it's almost like a starting lineup of a sporting team”, says Pretorius.

Each company within the portfolio is thoroughly vetted by a dedicated research team of 29 analysts located across key financial hubs, including New York and London.

The selection process prioritises diversity in growth drivers and market exposures, ensuring that the portfolio remains balanced without significant cyclical exposure. This “lineup” approach balances stability and growth potential, aiming to perform consistently regardless of broader economic cycles.

Beyond the starting lineup, Ninety One maintains an investable universe of around 70-100 companies. These are regularly monitored and kept ready for potential inclusion in the portfolio should market conditions or valuations become favourable.

This approach allows for strategic agility, enabling Ninety One to dynamically respond to changing market conditions and ensure that the portfolio remains aligned with long-term goals.

Diversified exposure for Australian investors

For Australian investors, Pretorius highlights the strategy's advantage in providing access to leading global companies and sectors beyond what is typically available in the Australian market, which is heavily weighted towards commodities and financials.

Investing in the strategy might include a global technology or healthcare leader that an Australian investor wouldn’t ordinarily have in a domestic portfolio.

Motorola Solutions (NYSE: MSI) is provided as an example, which serves as a vital communications provider for emergency services. Its defensive nature and consistent demand demonstrate the type of niche yet resilient businesses the strategy targets.