Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 325

Business quality matters most

In the future, when you wake up your hot coffee will be ready, the fridge will have reordered your groceries and a drone will already have delivered them that morning. A digital assistant will inform you it’s a little chilly outside and summon your autonomous vehicle to take you to the office. While there, you will collaborate in virtual reality with colleagues around the world, as high-speed internet makes the link-up as clear as real time. Later you will go to your friend’s 150th birthday party.

This might seem like science fiction, but it is a reality well underway to being created by some of the world’s highest-quality businesses such as Alphabet, Amazon and Microsoft.

Our focus has always been on quality businesses. For us, this approach makes a lot of sense – by looking only at those companies that we consider have the best economics, we are setting our investors up for better outcomes as well as reducing the risk of material capital losses.

There are thousands of companies listed on world exchanges yet we regard our eligible universe of potential investments to be only about 150 companies. These are the businesses that we have deemed to be of sufficient quality to consider for investment, a hurdle that requires a rigorous dive into the economics of the business and the industry in which it operates.

But what does quality mean?

For us, the largest determinant of quality is the presence of an ‘economic moat’; that is, a sustainable competitive advantage that protects the economics of the business and enables it to accrete value for its shareholders over time.

However, it’s not just about identifying the existence of such an advantage, but also identifying what are the key factors driving that advantage and how dependent the business is on good management for generating these robust outcomes. Sometimes the truly strong businesses are revealed when even poor management teams are unable to undo their favourable economics!

If, however, businesses can be identified that have strong moats, have sensible management as agents of shareholder capital, possess the ability to invest capital at high rates of return and have predictable outcomes or discernible tailwinds that can be used to build conviction, then we are positioning our lens towards those businesses that are most likely to succeed. This is at the core of what our investment committee process seeks to achieve. 

Of course, the subsequent step is to determine which of these stocks is then trading at a reasonable price, and then (subject to portfolio construction considerations, including risk controls) which high-conviction investments will be made at a point in time.

Sustainability in moats

The factors that drive an economic moat can be varied and evolving. The business might have a structural or size advantage that enables it to be the lowest-cost producer and beat its competitors on price such as Google can via the return on investment achieved by advertisers on its platform and can Lowe’s, the US retailer of home-improvement goods. The business might own a unique brand or franchise that resonates with its customers, conferring it with true pricing power as has French luxury-goods conglomerate Louis Vuitton-Moët Hennessy.

A network effect or two-sided market is another source of moat that is incredibly difficult to unwind. This is evident in the platforms operated by payment networks such as Visa. In this case, the two sides –  card users and card-accepting merchants – support the utility of the platform. That is, the more Visa card holders there are, the more vendors want to accept them, and the more places that accept cards, the more people want to use them. This network is self-reinforcing over time: since the first cards were issued in 1958 Visa’s network has grown into a business that intermediates more than US$11 trillion in global payments spent via  3.3 billion cards issued by 16,000 financial institutions connected to 50 million merchants worldwide.

Identification of risk

Equally important to this discussion, however, is the question: Are the advantages we have identified sustainable? This is a critical piece of our analysis as our assessment of quality must be forward-looking. It might be tempting to look at history alone and see which businesses have had the best returns on capital over time, but this might prove to be a poor guide as to the business’s future.

Identifying quality goes hand in hand with identifying risk. Disruption, though an emotive word, whether driven by changing technology or changing consumer preferences, in reality simply reflects the way people are now and will in future live their lives.

The earliest two-sided markets were newspapers, where greater readership encouraged greater advertising sales upon the limited real estate of the printed page. Only one side of such a market needs to be disrupted for the network to collapse; in this case, as we all know, it was the movement of readership onto online platforms and away from print.

Advantages related to the low-cost labour in certain countries are being disrupted as the cost of capital goods declines rapidly. A robotic palletiser used to move product from distribution centres through to supermarket shelves now costs only US$25,000 compared to US$1 million five years ago. This means that for many multinationals seeking to cut costs, it now makes sense to replace low-cost labour in emerging economies with low-cost capital – a remarkable shift in relative advantages. Unilever, for example, added 1,000 robots to its cohort in the last year and intends to grow this to a fleet of 10,000 in coming years. Nike is investing in localised manufacturing, intending to autonomously produce customised footwear on demand.

And, of course, Amazon has changed the playing field for retailers and goods producers alike in its ongoing drive to lower prices and usurp commoditised brands with its own.

Further, there is indeed a plethora of other disruptive factors at play, including cloud computing, the dominance of social media, growth in on-demand video content, the trend towards health and wellness, and automated manufacturing and advancement in artificial intelligence technology among many others that require careful analysis of the implications for businesses.

It is important to identify whether or not a company will be a winner from these changes, be immune or be threatened and, if the latter, will it suffer a mere speed hump or face an existential threat to the moat around its business? Some of these identified risks might take 10 or 20 years to play out.

At Magellan, this focus on quality businesses such as Alphabet, Amazon, Microsoft and others represents the core of our investment philosophy and goes directly to achieving our investment objectives of absolute returns coupled with capital protection for investors.

 

Vihari Ross is Head of Research at Magellan, a sponsor of Firstlinks. This article is for general information only and is not investment advice. It does not consider the circumstances of any investor.

For more articles and papers from Magellan, please click here.

 

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.