Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 67

Quality over quantity: a lesson of value

There are, broadly speaking, two kinds of stock market investors in this world: those who believe they can beat the market and those who don’t. The latter group of investors tends to buy index-style funds that hold shares in nearly every company in proportion to their index weight to ensure delivery of the market return, net of fees, with little deviation.

But what about the former group of investors? One philosophy which has demonstrated sustainable outperformance of the market over long periods of time is that of ‘value investing’. Under this philosophy, the investor will hold shares in fewer companies which are of relatively higher quality and purchased at relatively lower valuations.

While many subscribe to these ideas, putting them into practice is not a trivial task. One area that many investors grapple with is articulating precisely what constitutes a ‘high quality’ business. One way to think about the quality of a business is to answer the following question: how easy would it be for a competitor to recreate the business? If the answer is ‘very easy’ – as would be the case for, say, a corner store, then the quality of the business is low. On the other hand, if the answer is ‘very difficult, time consuming or costly’ – as is the case for, say, Facebook, then the quality of the business is high.

When thinking about how to answer this question, one can think of three key sources of quality. A business can be qualitatively evaluated for these elements with a check-list type approach. The three sources of quality are: economies of scale, customer captivity and government protection, such as licenses or patents.

Economies of scale relate to the dynamic of bigger businesses exhibiting a cost advantage over smaller businesses. When fixed costs can be spread across a larger quantity of goods and services, average unit costs are lower. Furthermore, bigger businesses can exhibit stronger bargaining power over suppliers and drive more favourable terms than smaller businesses. We are seeing this dynamic all too clearly in the Australian supermarkets space.

Customer captivity relates to the ease with which customers can switch to a competitor. A business that has a large degree of customer captivity is often more successful in pushing through higher prices. There are various forms of customer captivity. These include integrated systems between the business and its customers, as is the case for Visa and Mastercard, as well as customer loyalty programs that effectively increase the cost for customers to switch.

Finally, when a business has privileged access to resources or a patent, this represents an advantage that cannot easily be recreated by competitors. For instance, one of the reasons why BHP is such a world-class business is because it has government-protected rights to mine the natural resources of Australia and other nations. Without these rights, the company’s quality would be severely impaired. Patents on new technology create a similar degree of quality to the extent they are protected by the government.

Value investors will aim to hold portfolios of shares in companies that exhibit many of the elements described above. As long as the investor does not overpay for these businesses initially, they can be reasonably assured of market outperformance over long periods of time. These principles of value investing are worth keeping in mind for both individual investors as well as those looking to evaluate the investment managers of externally-managed funds.

 

Andrew Macken is a Senior Analyst at The Montgomery Fund

 


 

Leave a Comment:

RELATED ARTICLES

What makes a company attractive?

Learn your knowns and unknowns

Value investing and valuing a business

banner

Most viewed in recent weeks

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 606 with weekend update

The boss of Australia’s fourth largest super fund by assets, UniSuper’s John Pearce, says Trump has declared an economic war and he’ll be reducing his US stock exposure over time. Should you follow suit?

  • 10 April 2025

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Latest Updates

Investment strategies

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Investment strategies

Does dividend investing make sense?

Dividend investing offers steady income and behavioral benefits, but its effectiveness depends on goals, market conditions, and fundamentals - especially in retirement, where it may limit full use of savings.

Economics

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Strategy

Ageing in spurts

Fascinating initial studies suggest that while we age continuously in years, our bodies age, not at a uniform rate, but in spurts at around ages 44 and 60.

Interviews

Platinum's new international funds boss shifts gears

Portfolio Manager Ted Alexander outlines the changes that he's made to Platinum's International Fund portfolio since taking charge in March, while staying true to its contrarian, value-focused roots.

Investment strategies

Four ways to capitalise on a forgotten investing megatrend

The Trump administration has not killed the multi-decade investment opportunity in decarbonisation. These four industries in particular face a step-change in demand and could reward long-term investors.

Strategy

How the election polls got it so wrong

The recent federal election outcome has puzzled many, with Labor's significant win despite a modest primary vote share. Preference flows played a crucial role, highlighting the complexity of forecasting electoral results.

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.