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

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

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.

Latest Updates

Economy

The ‘priced out generation’ and what they should do about it

A fiery interview on housing exposed deep generational divides, sparking youth outrage and political backlash. As homeownership drifts out of reach, young Australians face a choice: fight the system - or redefine success.

Taxation

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.

Superannuation

Meg on SMSFs: Ageing and its financial challenges

Ageing SMSF members can face issues funding their pension income as cash reserves dwindle. Potential solutions include involving adult children in contributions to secure future financial stability.

Economy

US earnings season was almost too good to be true

The second quarter US earnings season has wrapped up, with a record 82% of S&P 500 firms beating earnings estimates. As tailwinds fade, Q3 may reveal whether AI momentum can offset rising economic headwinds. 

Gold

Does gold still deserve a place in a diversified portfolio?

9,000 years and no devaluations later, gold is the world’s most enduring store of value. It remains attractive as the value of several paper currencies, including the US dollar, are threatened by deficits and rising debt.

Shares

Checking in on the equity market's silent engine

Consumer spending directly impacts corporate earnings, sector performance and market sentiment. The latest data from different economies uncover risks and pockets of opportunity for investors.

Fixed interest

6 key themes driving bond markets

The Fed could soon be prompted to join other central banks in cutting interest rates. This would have ripple effects across global fixed income markets and provide an especially attractive backdrop for emerging market bonds.

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.