Investing is both a comfortable and tough job. The present value of future cash flow determines shareholder value. Nonetheless, in terms of the very majority of the future, it is quite impossible to predict on a consistently accurate basis. Meanwhile, the good news is that investors, unlike many other roles, do not have to make difficult calls.
At Urbem, while we acknowledge the prevailing excitement of stepping into the unknown, we also believe that investors can have a significant edge by focusing on the known knowns. A discipline of staying within a circle of competence is crucial. In this sense, emotional quality matters much. As Warren Buffett (Trades, Portfolio) pointed out, investors with high IQs may be better off selling some points to someone else. He also refers to the Science of Hitting, demonstrating the greatness of the investing job - you do not have to swing at every pitch, and patience pays off handsomely in the long run.
For those with the necessary emotional intelligence, we think that easy calls do exist in the investment world. First of all, some business models do offer more predictability than others. For instance, a software-as-a-service (referred to as "SaaS") model with high customer stickiness (often due to the switching cost) provides high long-term visibility into the future cash flow. Take a look at Craneware (LSE:CRW), which achieved an over 100% renewal rate in dollar value for its annuity type of business model. Over the past decade, the Scottish company delivered a consistently high return on capital with a stable payout ratio. Similar to SaaS, the installed base is another common source of recurring cash streams. Companies like Waters (NYSE:WAT) derive a significant portion of their revenue from aftermarket sales, including consumables and services. Furthermore, franchisors such as Choice Hotels (NYSE:CHH) have a strong brand and protection through long-term contracts, generating predictable royalties that are high-margin and cash-rich.
Alpha-seeking investors can also look for things that change little over time. Century-old brands like Brown Forman's (NYSE:BF.A) (NYSE:BF.B) Jack Daniels and Hermes (XPAR:RMS), which have endured the World Wars, the Great Depression, the Financial Crisis and so forth, are likely to have solid long-term prospects compared with most technological innovations.
Lastly, in terms of industries, we favor those selling small-ticket, repeatable, every day, nondurable items. If the business can protect itself through a sustainable advantage of a brand or low-cost production, the volume can be highly predictable. For example, Clorox's (NYSE:CLX) cleaning detergent is being used by over two-thirds of American families. The company also shares almost one-third of the U.S. all-purpose disinfectant market and has been holding a top position in the categories of water filtration, charcoal and salad dressing for years. For the next 10 years, would you like to be in the shoes of placing bets on the continuous dominance of Clorox in its consumer staples space or the success of Tesla's (NASDAQ:TSLA) turnaround?
Disclosure: The mention of any stock in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Craneware, Waters, Hermes and Clorox.
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- Urbem's 'Quality Strategy' Series: The Management
This article first appeared on GuruFocus.