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Urbem's 'Quality Strategy' Series: The Quality of Earnings Growth

To gauge valuation, many investors mainly look at the quantity and growth of earnings. At Urbem, we believe that the quality of earnings growth actually matters more. Not only should a poor quality of growth considerably lower the fair valuation, but it also might indicate weaknesses or risks in business fundamentals, causing challenges in valuing the company properly.

We have developed our proprietary factor-based approach to evaluate the quality of earnings growth from a long-term investor's perspective. Ideally, we would love to see an increase in earnings per share (referred to as "EPS") that is supported by a sustainable, organic top-line growth based on a predictable, recurring sales model, highly convertible to cash and minimally dependent on capital spending.


Return on Capital

In his 2007 letter to shareholders, Warren Buffett (Trades, Portfolio) addressed the categorization of business growth - "the great, the good, and the gruesome" - based on the rate of return on invested capital. The great company burns little capital to generate a sizeable increase in profits, as evidenced by See's Candy (BRK.A) (BRK.B) according to Mr. Buffett and OTC Markets Group (OTCM) in our view.

Cash Conversion

Not all booked profits result in cash for shareholders. At Urbem, we highly appreciate cash-generative earnings. One useful metric, in our view, is the cash conversion rate. Many wonderful businesses deliver more free cash flow than earnings every year, reflected by a cash conversion rate consistently above 1x. How is this possible? They may achieve this through a robust prepayment revenue model (e.g., Domino's Pizza (DPZ)), a bargaining power with suppliers (e.g., Apple (AAPL)) or a conservative accounting approach.

Predictability

Predictability reduces investment risk for equity owners, and hence, makes earnings more valuable. Where can we find this measure? First of all, businesses with large economic moats (e.g., Hermes International (XPAR:RMS), which has survived and thrived for more than a century) face less competitive risk and often give shareholders peace of mind in this dog-eat-dog capitalist world. Secondly, a stable and even "boring" industry (e.g., Rollins (ROL) and its pest control industry) generally sees less disruption than a fast-moving one filled with excited innovators (think of any new technology field). Moreover, a recurring business model with a superior retention rate (e.g., Technology One (ASX:TNE) and its Saas-driven business) can shed light on long-term visibility of future cash flow. Lastly, we find companies selling small-ticket, nondurable, business-to-consumer items (e.g., Church & Dwight (CHD)) particularly attractive, as they are less sensitive to economic cycles

Acquisition

Research shows that two-thirds of acquisitions do not end well for shareholders. The main reasons have been overpaying and integration. A few companies also conduct acquisitions to implement their diversification (or "diworsification") strategy, which we are generally against. While some companies, such as Berkshire Hathaway, have the necessary skill and discipline to make buying businesses a successful income strategy, we must admit the scarcity of great capital allocators in today's business world. For a growth strategy relying on acquisitions, we highly recommend that shareholders pay close attention to the evolvement of capital efficiency, profitability and asset quality over time.

Share Repurchase

Mathematically, fewer shares outstanding lifts EPS, given that everything else is equal. Nonetheless, it is worth noting that not all share buyback programs are "meaningful," especially if they are not conducted at a reasonable price. In this regard, we highly appreciate management with a shareholder-friendly and prudent capital allocation mindset. For example, Credit Acceptance (CACC) explicitly expresses in their policy that excess cash can be used to repurchase shares only when the share price does not exceed the estimate of the intrinsic value.

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 Berkshire Hathaway, OTC Markets Group, Hermes International, Rollins, Domino's Pizza, Technology One, and Credit Acceptance.

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