Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 78

What makes a company attractive?

In every investment magazine and the business section of weekend newspapers you will see a list of hot stock picks from fund managers. Inevitably these picks won't represent the fund manager's top new ideas, but rather five large positions in the funds they manage. You will never see the fund manager's recently uncovered gems in print, as the managers will be busily building these positions in their portfolios and certainly don't want other investors driving up the price! In the interests of disclosure I have been guilty of doing this myself. In this piece, I take a step back and look at what actually makes a company an attractive investment.

Easy to understand

We are attracted to companies with business models that are simple and can be explained to any client in two sentences or less and where it can be easily identified how the company makes money. Woolworths' business model is very simple; they buy groceries and liquor from the manufacturers and have the cheapest mechanism for distributing these goods to the consumer.

This point is frequently forgotten during market and credit booms, where complicated businesses thriving off accounting or credit arbitrage can appear to prosper for a certain amount of time. In 2006 I had several meetings with Allco Finance's management in an attempt to understand the business. The company's share price had risen 120% in the previous year and not owning it in the portfolio was hurting performance on a relative basis. After the management was unable to explain how Allco made money sustainably, we did not invest. It was bankrupt in the GFC.

Low capital requirements

The best companies to invest in are those that require minimal ongoing capital expenditure to generate a profit. When a company is required to continually make investments just to stay in business, this represents less cash that is available to be returned to shareholders. Pharmaceutical company CSL requires minimal ongoing capital expenditure to produce its medicines outside the company's research and development budget and this has allowed the company to return $6.1 billion to shareholders since 2010 in dividends and share buy-backs. Conversely Qantas is a capital heavy business which constantly needs to invest (an A380 costs US$414 million) just to remain competitive in the aviation marketplace. Since 2010, Qantas' annual capital expenditure has been consistently ahead of the cash flow it generates from its operations, which explains why shareholders last saw a dividend in 2009.

Strong barriers to entry

Strong barriers to entry discourage competitors from entering into the market and thus reducing profit margins. Toll road operator Transurban enjoys high barriers from long-life monopolistic assets. There is zero probability of a competitor building a toll road adjacent to the company's M2 Hills Motorway in Sydney. Conversely, online accommodation company Wotif.com initially enjoyed strong growth after listing in 2006, but has seen its share price and market share fall dramatically, as larger global competitors improved their internet offer. In Wotif.com's case along with many other tech companies, the barriers to entry tend to be quite low. Generally high barriers to entry, if they can be maintained, translate into higher profits for shareholders.

Non-reliance on government legislation or a single customer

Owning companies whose business models depend on favourable government legislation can be soul-destroying for investors. Investors in Timbercorp and Great Southern saw these billion dollar companies disappear after the government changed the tax treatment of their agricultural schemes. More recently, salary-packager McMillan Shakespeare's share price fell 55%, wiping $600 million off the company's market capitalisation in 2013 after the government proposed changes to the salary packaging of car leases. Similarly, a month ago, former market darling Navitas' shares fell 30% after key partner Macquarie University announced plans to bring Navitas' university pathways program in-house. Alternatively food and beverage packaging company Amcor attracts very little interest from governments and has a large global spread of customers. Companies with these characteristics tend to have easily forecastable earnings with far fewer nasty surprises for investors.

Quality management

When we invest in a company we are effectively entrusting our investor's funds with a company's management and entrusting them to both grow that capital and provide a stream of income. A key part of the investment process is an assessment of a management team's competence to run the business and act in the best interests of shareholders. As a fund manager when I walk into a palatial office suite, not only do I see that my investor's money is paying for that flashy office with the harbour view, but also the management are unlikely to be serious in cutting costs during the down times. Walking into CSL's office in suburban Melbourne is like stepping into an unrenovated government office building from the 1960s and then in the boardroom it is clear that management are both highly competent and are focused on shareholders.

Furthermore in assessing all companies in our universe we examine executive remuneration versus total shareholder return and penalise companies that are paying management teams that are not delivering returns for shareholders.

We view that over the long term and across a range of market conditions, outperformance will be delivered by owning a portfolio of companies with stable and growing dividends and earnings that have an easily understandable business with barriers to entry that protect margins, have transparent financial accounts and trustworthy and shareholder-friendly management teams.

 

Hugh Dive is Head of Listed Securities at Philo Capital Advisers where he runs a $550 million portfolio of Australian shares. This article is general in nature and readers should seek their own professional advice before making any financial decisions. Companies mentioned are for purposes of illustration and education only.

 

1 Comments
Tortoise
September 04, 2014

So you pretty much follow the Buffet principles.

 

Leave a Comment:

RELATED ARTICLES

How do different investing styles work?

Cheap stocks: how to find them and how to buy them

Learn your knowns and unknowns

banner

Most viewed in recent weeks

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are franking credits worth pursuing?

Are franking credits factored into share prices? The data suggests they're probably not, and there are certain types of stocks that offer higher franking credits as well as the prospect for higher returns.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Latest Updates

A nation of landlords and fund managers

Super and housing dwarf every other asset class in Australia, and they’ve both become too big to fail. Can they continue to grow at current rates, and if so, what are the implications for the economy, work and markets?

Economy

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Retirement

Retiring debt-free may not be the best strategy

Retiring with debt may have advantages. Maintaining a mortgage on the family home can provide a line of credit in retirement for flexibility, extra income, and a DIY reverse mortgage strategy.

Shares

Why the ASX is losing Its best companies

The ASX is shrinking not by accident, but by design. A governance model that rewards detachment over ownership is driving capital into private hands and weakening public markets.

Investment strategies

3 reasons the party in big tech stocks may be over

The AI boom has sparked investor euphoria, but under the surface, US big tech is showing cracks - slowing growth, surging capex, and fading dominance signal it's time to question conventional tech optimism.

Investment strategies

Resilience is the new alpha

Trade is now a strategic weapon, reshaping the investment landscape. In this environment, resilient companies - those capable of absorbing shocks and defending margins - are best positioned to outperform.

Shares

The DNA of long-term compounding machines

The next generation of wealth creation is likely to emerge from founder influenced firms that combine scalable models with long-term alignment. Four signs can alert investors to these companies before the crowds.

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.