Book review: Quality First Investing

As you might notice. I am writing this post in english, and that also applies future posts. It's not my natural language, so the linguistic quality, if any, will not be as high as before, but the posts will be more accessible and could reach a wider audience (I hope there could be one!).

Now to today's topic. I have read Quality First Investing: A checklist approach to finding and sitting tight in multibaggers by Björn Fahlén. 

In short

It has been a very pleasant read and a thought-provoking reading experience. My review can in no way do the book justice. My simple message is therefore: Buy the book, read it, and you will most certainly develop as an investor. It is a great resource for making and evolving your own checklist and finding your strategy as well as your strengths and weaknesses. For me, it is a must-read.

I put this book in the same category as One Up on Wall Street and Why Moat Matters, the books I have re-read most times. They all have the qualities of a timeless subject, a large scope and practical approach. The purpose is in some way to be used as a tool, checklist and encyclopedia, and I must say that it works very well. They all succeed in being comprehensive but concise and fall into the "easy to read but hard to digest" category (in a positive way). The books all make you think deeper than before. 

A more detailed look

The approach is long-term investing in quality companies (as you would have guessed). It is divided in the following chapters, where the first three are of paramount importance:

• People tenets
• Business tenets
• Financial tenets
• Bringing it all together
• Appendix

For people tenets some takeaways/quotes/nuggets are that "great management teams deliver positive surprises and bad ones negative surprises". That is so true, and I immediately have some companies that come to mind here. And business passion is extremely important. The question really is: "Is this person going to dedicate his or her life to make something extraordinary happen?". When it comes to ownership: "Controlling owners typically avoid excessive leverage and use retained earnings rather than serial equity offerings to grow. Also, independent thinking is easier in companies with dominant shareholders, as they typically focus on the long term with respect for a strong corporate culture". 

Examples of questions to ask: How long have the CEO and senior management worked together? Is there a differentiation strategy, aiming at product leadership, customer experience or being a low-cost provider? Is the capital allocation sound and has acquisitions created value for shareholders? Are good and bad news communicated with the same degree of regularity and are the same "story" and key metrics used? Is compensation to management reasonable measured against total shareholder return?

For business tenets, some takeaways are that "If you don't understand the competitive environment and don't have a clear sense of how the business will engage customers, create value and consistently deliver that value at a profit, you won't succeed as an investor. The key is to identify the factors that will produce future earnings and be able to make a reliable forecast of them." And when it comes to recurring revenue, something to look for are when "...the customer is renting the product, not owning it" or when "...the product is consumed daily or weekly by customers and will need to be purchased again quickly, no matter how the economy is doing". And "History shows that many of the best-performing investments are found in slower growing industries powered by long-term tail winds".

Examples of questions to ask: Does the business have scalability and recurring revenue? Does the business have embedded optionality? An asset-light model? Long term tailwinds? Does the business operate in a slow-changing market with long product cycles? Is there limited competition and risk for disruption? Do the products provide unique and desired benefits to customers? Is there a moat? Are the products for the greater good?

For financial tenets, the takeaways for margins are that "An improvement in margins requires lower cost and/or higher prices for the company's products. Steady growth in profit margins over a number of years is a strong indication that the company is doing well". And "...a high gross margin is the best defense against inflation". For growth "...sales growth is a good representation of a company's ability to take market share and/or partipicate in a growing industry. And EPS growth is an indication of a company's ability to increase earnings - whether through better sales, good control of expenses or a combination thereof". And "you should generally avoid the most aggressive growth companies as they are the most vulnerable to overvaluation, multiple fade, and competitive business pressures".

Examples of questions to ask: Has ROA consistently been above the industry average? Is the average ROE at least 20% for the past five years? Does ROE appear unsustainably high? Is operating margin (EBIT) above the industry average? Has Net Profit Margin been positive over the past 10 years? Have EPS increased in each of the past five years? Have EPS grown at an extreme rate over the last three years? Is the company in good financial condition and is the quality of the company's earnings high?

When bringing it all together there is a very interesting discussion about patience, compounding, time and valuation. Stocks are also divided into three buckets, long term compounders, emerging compounders and deep value special situations. This chapter summarizes the book and philosophy well.

How will I use the book? 

As a background you are very welcome to read my own short investing checklist (use translate). My checklist is still something I will follow but it will certainly develop over time and the book has given valuable insights that will take time to digest. This is what I will work further on and some that I will start doing immediately:

• When evaluating companies, I will always have people, business and financials in mind.
• I will read the book regularly to add knowledge and remind myself of all perspectives. That's especially useful when it comes to my weaker spots. 
• In my case, people tenets is something that I must evolve. I might have looked too much on "static" numbers like free float, family owned yes/no etc. and too little on the actual owners, motives, long term goals and signs of true passion. I have to question more and dig a bit deeper.
• I will try to climb up some steps on the quality ladder when choosing companies. I might have a tendency to sometimes buying very cheap companies, still of decent quality, but definetly value first, high quality second (referring to the title of the book)
• Certainly I will look more at business scalability to be able to catch more multibaggers. I will try to shift my perspective from not only 3-5 years, but to 10+ years, even if that's a hard thing to do.
• I will think more about the rate of change in the industry and product cycles in a "moat" context. I do like timeless products (referring to this blog post), but will link that perspective more to the moat.
• I will use the book for adding new red flags and reasons not to invest in certain companies.
  
  

And some highly subjective "additions" and discussion points

Investing is a personal subject. When reading the book, I couldn't help to think of some things which I emphasize, but that are not covered as much in the book. I can, perhaps, take the time to add what I also look at in more detail. This is no flaw in the book, just some discussion points, personal flavor, and (highly) subjective additions that I use, and will continue to use, in my investing process. 

• Country risk/democracy? I look a lot at country risk, both in revenue and from a listing perspective. As a global investor, seeing other investors sometimes going to risky geographies or taking unwanted or unknown risks, I know this is always important. It may fall under "regulatory risk" and overall risks mentioned in the book but you can argue that it goes even deeper. Also, you could argue that a country level could be included in the ESG-discussions, even if that's not standard practice. Some, again subjective, thoughts can be found in the blogposts, Ok countries to invest in and ESG on a country level and thoughts on China (use translate). And it is not only about risk. In fact, it is very interesting that democracies tend to have better stock market returns, as recent studies suggests. 
• Demography as a megatrend? The question is if demography in one way is the most important megatrend, being more certain and simpler than some of the others. I have put a lot of weight on this one (being a fan of Hans Rosling). Demography serves as a positive background for my investments in ASEAN companies. These markets are also a bit underrated for other reasons. I cover these subjects in Right view on the world when you invest? (use translate). 
• Local moats or global? The question is always whether a company should or shouldn't expand abroad. I own some local Indonesian/Philippine consumer stocks. And yes, the risk is higher being in just one market, but it also makes sense staying in your country (where you are superstrong). At least if that growth is enough (I hope that is the case of my Southeast Asian stocks). In some sense, all competitive advantages are local, and it is, at least for some type of businesses, not an easy discussion if global, or "just" local competitive advantages, is something to strive for. 
  

And finally, being a bit theoretical. Growth in revenue and earnings is normally what counts. But could a "growth company" sometimes, in very unusual, deep value situations be a non-growth company in revenue? For more thoughts on this subject, fellow blogger Framtidsinvesteringen has a good post (use translate).

Summary

I can highly recommend the book and the approach to investing it describes. As I said before, my simple message is: Buy the book, read it, and you will most certainly develop as an investor. It is a great resource for making and evolving your own checklist and finding your strategy as well as your strengths and weaknesses. For me, it is a must-read.