The secret to a quality company

It was the father of Value investing Benjamin Graham who first recognised the benefits of investing in quality companies. Graham found that investors suffered the greatest losses not from buying high-quality businesses at high prices, but from buying low-quality stocks at prices that seem fair. 

The secret to identifying high-quality compounders is strong environmental, social and governance factors. These criteria can make or break the long-term returns of a business, with a focus on ESG helping to ensure the sustainability and longevity of a company's future. 

In this Q&A, Morgan Stanley Investment Management's Bruno Paulson explains the makings of a high-quality company, why Facebook doesn't cut it in his strategy, and the investment case for companies with intangible assets. 

ESG has become quite trendy in recent years, aside from the ethical and sustainability-related benefits, what is the advantage of investing with ESG principles in mind?

Well, we look to invest in compounders, that's really high-quality companies with high returns, capital recurring revenue, and we're investing for the long-term. And if you're doing that, then you really need to think very hard about these environmental, social and governance issues, which can impact returns for the long-term or improve them. So I would say if you want to be a proper long-term investor, you cannot neglect these issues these days.

Because of this, there's been an explosion of ESG products recently. What makes your strategy different to its competitors and how can investors avoid the greenwash? 

I think firstly, you've got to be very clear about what kind of ESG you're looking for. Because there are different kinds, they're all put in the same bucket. So one form of ESG investing is impact investing and in my view, that's where your primary goal is not making a return on your money, the primary goal is to change the world. 

That's not what we do. Our team runs a process where ESG is fully integrated into the process. And we also avoid some of the controversial sectors, be they the carbon-heavy sectors like utilities and miners or tobacco and alcohol. But the primary goal is to generate strong returns. 

I think what's distinct about us is you have a team that has been invested in high quality companies for decades with a long-term track record of investing in high quality. And you combine that high quality and strong historical returns with this focus on ESG.

Is it possible you could provide some examples of how you incorporate ESG principles into your investment decisions?

I think one clear example, and it's a pretty topical one for Australia, is Facebook. Now, on the face of it, Facebook is a very high-quality company, it is very profitable, it has fine growth prospects, and a lot of the times it's been at a perfectly reasonable valuation. But for us, it's not been investible and that's been because of ESG factors and in particular, the social factor. 

Will it be able to continue to make money at the same rate? Because there are the privacy concerns, there are the antitrust concerns, there's the paying for content concern, there are content moderation concerns. And on top of that, we have deep worries about governance, which is, it's basically run by one person with very little check and balance and control on it. And so for us, although Facebook ticks a lot of the boxes as a high-quality company, it's uninvestable to us because of ESG factors.

From what you just said, it sounds like you use a lot of qualitative factors. Do you use quantitative factors as well in your investment decision process?

Obviously, at the core of the investment process, we are running financial models and so on. When it comes to the ESG element clearly around carbon, then you're quantifying that, quantifying the effect of higher carbon costs on your profitability, if the tax rate is low, we quantify the risk of a higher tax rate and the impact that might have on earnings. But a lot of it is naturally qualitative and soft and it's around the culture of companies and what material risks and opportunities there are from these ESG factors.

How strict is your ESG process? Is there room to invest in companies that are working towards becoming more sustainable, for example?

I think it is. And so if you take environmental factors, our investment process excludes the very carbon-heavy sectors anyway, because they're not the kind of high-quality companies I talked about, they have low return on capital, they're highly cyclical. But we are engaging with our universe at the moment, pushing the companies all to make promises of carbon neutrality, some like Microsoft have already gone to carbon negative. But yeah, even where companies have ESG issues, if we can be convinced that they're confronting them, dealing with them and moving in the right direction, then that's acceptable.

Are ESG businesses at their core quality businesses then?

I would put it the other way around. I would say quality businesses at their core have to be good at ESG. Being an ESG business is necessary, but massively not sufficient in order to be a high-quality business. If you're in the wrong sector, however hard you're trying, it's just not going to cut it for us as a quality business.

Do you prefer to invest in tangible assets or intangible assets, and why?

We massively prefer intangible assets. And what we mean by that is things like brands or networks, for example, everyone uses Visa or Excel because everyone uses Visa and Excel. And we massively prefer them to tangible assets because they're much more difficult to copy. 

It's quite easy to build another mine or drill another hole or build another factory. It is very difficult to replicate the billions of cumulative advertising that is being put into some of the consumer brands. It is very difficult to break into the Visa or MasterCard duopoly. 

And so we find that we can have much more confidence in the long-term path of profits for companies with intangible assets than tangible. And in addition, an extra bonus is that you're not having to invest tonnes of capital. So when you do earn money, it does actually turn into cash and doesn't have to be pulled back in the business to build another factory.

Are there any sectors in particular that you avoid?

Well, I think we can answer that two ways. So firstly, our team's strategy is very focused on three sectors, information technology and in particular software and IT services rather than hardware, healthcare and within healthcare life sciences and medical technology rather than the traditional pharmaceutical drugs, and consumer staples. So those are the three core sectors where you find most of these high-quality ESG-compliant compounders. 

The other way of looking at it is our team's strategy does not invest in certain sectors/areas: banks, miners, oil companies, utilities. And that's one attractive thing because we are quite diversified from the Australian market, we don't touch those low return on capital, cyclical, price taking commodity-driven industries.

You briefly mentioned consumer staples before. They have really benefited from the COVID environment. Do you think this growth is sustainable?

Elements of the consumer staple sector have certainly benefited. So, if you're in the hygiene and cleanliness business, then clearly 2020 has been a great year. For instance, for Reckitt Benckiser. However, there are other elements to staples which haven't benefited or have even suffered. So the beverages sector for instance, if the bars and pubs are closed, that cuts down a lot of the consumption of beverages. If you're a beauty company, then all of the department stores being closed and international travel being stopped does not help because a lot of the prestigious high margin stuff is bought in duty-frees around the world. And so although there have been beneficiaries, consumer staples haven't had a boom and in fact, they actually underperformed the index last year. The big beneficiary last year was technology rather than consumer staples.

Is it possible you could give us an example of a consumer staples company you invest in and give us the reason why?

Life for consumer staples has become a bit more complicated with the rise of e-commerce and digital advertising and so on. And so within consumer staples, you've got to focus in on the right sub-sectors of consumer staples; the right industries within consumer staples and also the right companies. 

One company we like is L'Oreal, it's in beauty. And beauty is a place where brand continues to be very important. People are not going to buy white label beauty products. And it's also an incredibly well-run company. So it's been the market leader in digital and that helped it a lot during the pandemic when all the department stores and duty-free was shut. And in addition, it is leading on ESG factors, particularly in areas like animal testing and using the right kind of ingredients. And that is one of the reasons why it continues to gain share. So L'Oreal, you've got an attractive industry (beauty) and a very well managed company, which is gaining share within beauty because it's doing the right things.

Software and IT have grown spectacularly over the last few years. Is this level of growth sustainable? Are we witnessing a slow down in this sector?

So software and services have gained. I think it was Marc Andreessen who said that software is going to eat the world as it takes on more and more things. And if you think of IT more broadly, you can think about how advertising has moved into the tech sector with online advertising. You think of e-commerce. And so it is a structurally growing area and will continue to be. 

It's been accelerated by the pandemic and it will be interesting to see whether there's a bit of a slow down as that reverses. But we do see it as continuing to grow healthily. I think within it, you've got different types of companies, right? Some are winners and some are losers. And the companies we own, the likes of Microsoft and SAP and Accenture and ADP, we think are reasonably valued, but you have had some quite bubbly behaviour within elements of the tech sector.

So, if you divide the tech sector into five quintiles or buckets by valuation, the top quintile has an average forward earnings multiple of 160x, it's incredibly expensive. And that's even before you count the price of paying people in shares. And that bucket went up 160% last year. So that's not value, and that's not investible for us. But we think that the slightly more boring technology companies are still perfectly, attractively valued and have decent growth prospects.

We've talked a lot today about your investment strategy, but I'd actually love to know a little bit more about you. What got you into financial services in the first place? What inspired you to work in investment management?

Well, it was a long journey. I started off as an academic and then as a management consultant, and then I got a chance to become an equity analyst working in the financial sector. And then I just got incredibly lucky and I got the offer to join this amazing team with these amazing quality, compounding products. And as someone who had spent a long time studying financials, I knew they weren't compounders, and therefore going and investing in compounders seemed particularly attractive.

Is there anything else other than investing and portfolio management that excites you or that you're passionate about?

I'm very involved in education. So my oldest son is on the autistic spectrum. So we founded a government school for him, and he's now in a mainstream school and I'm the governor there as well and help with the finances in these schools. So I do that a lot, and I'm also involved in various social mobility issues.

I love my job, but ultimately there's more to life than that. And so I get a buzz out of doing both paths and what surprised me, and I've been heavily involved in this for about a decade now, is just how valuable in the charitable sector is being quantitative and understanding finance. If any of you have some spare time and are numerate and can do a simple P&L and so on, I'm sure there are tonnes of charities out there that would love to use the help.