Anatomy of a great company

As stock pickers, the managers of The Brunner Investment Trust are looking for what they believe are great companies which can grow and deliver returns to shareholders. Whilst this may sound obvious, just what exactly are the common factors in the DNA of a “great” company? Joe Lynam quizzes portfolio manager Julian Bishop on how he and his team go about assessing companies.

This is a marketing communication. Please refer to the key information document or KID before making any final investment decisions. Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Past performance does not predict future returns. The mention of any particular security or strategy should not be considered as a recommendation. For further information on the Brunner Trust please go to www.brunner.co.uk.

JL: Hello and welcome to the 22nd and latest instalment of Connected Investor, the podcast from the Brunner Investment Trust. I'm Joe Lynam, the BBC World Service presenter and Newstalk business editor. And in this podcast, we're going to discuss the anatomy of a great company. What attributes do really good businesses possess? Obviously, it includes some management, but also intangible things such as culture within a company, and of course, intellectual property and perhaps the ability to know what customers want in the future. And how can weaker firms become great ones? Of course, we'll ask what all this means for investors in the Brunner Fund, and I'm joined as ever by the co-lead portfolio manager of the Brunner Investment Trust, Julian Bishop. Hey Julian.

JB: Hi Joe.

JL: Can we start at the very top. How would you define quality when it comes to successful companies?

JB: Sure, so, I think people who know. Brunner well know that we put a lot of emphasis on quality. So, we talk about having these 3 dials at our disposal. Quality, value and growth, and we want as much of all three of those things as possible, but we do put a lot of emphasis on quality, particularly, and at the moment, if you looked at our style, you know, if you did a risk analysis of our portfolio, we over-index to quality attributes.

JL: So give us an example of a business model that you think might create great companies.

JB: So, we put a lot of emphasis on quality at the Brunner Investment Trust and we often get asked what we think quality is and I would probably split it into two parts. I talk, firstly about value creation, so the ability of a company to create value, and then we'd also talk about risks. So, generally looking for companies that are lower than average risk. And the idea of value creation is quite nebulous and it's quite dry, sort of necessarily financial and in nature. But really, we're looking for companies that can get a very good return on the cash that they invest, when they're laying down capital to grow their business. And generally, almost by definition, if you like, companies that do create the most value, tend to have a relatively asset-light approach to their market. So, just as an example, we've recently bought shares in Autotrader, which is London-listed. You probably know it as a website where you can buy a second-hand car.

JL: I certainly do.

JB: So Autotrader, it's a 7 billion market-cap company. So, it’s worth £7 billion, more or less. Now, if you go down and look at their financial accounts. If you look at their balance sheet, you'd see on a balance sheet, something called net property, plants and equipment. So that's basically all the kit that they've had to buy to run Autotrader with time. And for Autotrader - the 7 billion market-cap value company - their PPE, so the amount it cost them to build it, it's £15 million. So next to nothing in financial terms. They'll probably make about £300 million profit this year alone. So, they're making 20 times in profit, what Autotrader cost to actually build. So that's a great example of a company that has created a ton of value, and they have this incredible website, very, very high share of all people who look for a second-hand car will go to the Autotrader website. And of course, all the second-hand car dealers who list their inventory on the website, pay to do so. So that's their business model. So, that's a great example of a company that has created a lot of value. And if you compare that to BP, for example, another London-listed company in the energy space, obviously. Their property, plants and equipment balance sheet is £80 billion. So, all the equity shareholders, debt holders invested £80 billion to create BP. And the market cap, the enterprise value of BP is actually just about £100 billion. So, £100 billion on an £80 billion invested capital base is obviously not indicative of a business that has been judged by the market to have created much value. And another way to think about that is BP this year, they'll probably make about £5.5 billion in profit. So that's a lot of money, obviously, but in the context of an £82 billion property, plant and equipment, it's actually less than a 7% return on that capital. And by the way PPE isn't the only aspect of investor capital, but it's probably the most important in general terms. So, if you bear in mind that you can get 5% on cash in the bank at the moment. You know, 7% return, given all the risks that BP has taken to get where they are, isn't terrific. So BP, it's not a big company because it's created a lot of value. It's a big company because lots of people have thrown a lot of money into it. Autotrader, on the other hand, is a company that has created a lot of value and developed this incredible market position. And what we often note is that industry structure is key. So, you have these companies that for one reason or another have just got themselves into an enviable position. So, I think in the example of Autotrader, they have just an incredible market share in what they do. You think about companies like Microsoft, for example, the biggest holding in Brunner. You think about the market position they have in office software, so Excel, PowerPoint, Word, Teams. You know, they just have this extraordinary market position - 400 million subscribers, and no real competition. I mean, who would be the alternative to Excel? There essentially isn't anyone. And so, the best businesses in our judgment generally have got themself to a position where they've established barriers to entry, they've established sustainable competitive advantages for whatever reason. They've been built without the need just to pump loads and loads of financial capital into the business. And so that, I think, is a great sort of definition of quality. And then, particularly when you marry that with longevity. So, this idea that a business still in 5, 10, 20, 30 years will be enjoying the same market structure, the same competitive position. That tends to be what we look for when we're looking for quality in our investments.

JL: When it comes to risk, Julian, how do companies handle that?

JB: I'll slightly change the question. I'll say, you know, how does quality relate to risk, in an investment context. So, I think equities are a very broad range of financial instruments. So, some equities are incredibly risky, you know. We all know examples of equities where people have lost 100% of their money.

JL: Technology especially.

JB: Yes, sort of classic, where the risk-reward payoff is very, very high. But we generally prefer to invest in companies which we judge to be at the lower end of the risk spectrum. I think there's an overlap here with quality, so a lot of companies we like best, for example, have very little or no debt. So, a lot of lower-quality companies, because the returns are poor, they have to resort to debt to raise the capital they need to expand. Whereas a lot of asset-light businesses, higher quality businesses don't. And there's no doubt about it, the more debt you have, the riskier a financial construct that company is. A lot of companies went into real trouble because of their debt over the long term. But risk more broadly, you know, we look for things like recurring revenues. So, companies that have great visibility into what their revenue streams will be, so subscriptions, so Microsoft. There's a good example here. Most people who use Office 365, their employer will pay for it on a monthly basis. So, you have great visibility into your revenues, you know, a wide range of customers and suppliers, that's sort of classic Porterian analysis, you know, where it's a company too reliant on a few suppliers, too reliant on a few customers. Generally, we want to avoid companies where that's the case. A lack of regulatory interference, so we generally prefer companies that aren't subject to regulation, because their, you know, risks can change the stroke of a bureaucrat's pen. But more generally, we're just looking for companies which we think have predictability, longevity, for long-term contracts, sticky customers. All these things, we believe, reduce the overall risk profile of a company, and that has, you know, we think, profound implications for how you should value it.

JL: What about the ability to kind of see trends, to see where the market is going? How important is that in making a great company?

JB: I think that's absolutely vital, and to some extent companies can respond to what they see, but in some, they're relatively passive, you know. They’re sort of corks floating on an ocean, bobbing around. But I think the very best management teams absolutely will be able to see, anticipate and respond to what's happening in their industries. I think a lot of our companies, I would argue, are in great end markets where we think the growth is assured, but in some other markets, things are much more fluid. So, technology is often an example of an industry where things change very, very rapidly. Microsoft, for example, I think, you know, it was initially a huge success when it was Bill Gates, when it was the personal computer, etc. And then they had a failure of response in relation to the internet. So, I think there was a time when Microsoft was slightly struggling. They didn't quite foresee the rise of the smartphone. I think Steve Bulmer, who was the CEO at the time, made some very dismissive comments about the number of people who would have like a computer in their pocket. So, they at that point failed to anticipate change. Since then, under the leadership of Satya Nadella, and this comes back to the issue of quality management perhaps, they've done a much better job of responding to all the big trends that have taken place within technology. So, they were well ahead of the curve when it came to the development of cloud computing, for example, and they invested ahead of that, and became one of cloud computing's great winners. At the moment, of course, there's lots of interest in artificial intelligence, and Microsoft there had this pretty early stage stake in Open AI, which is the company behind Chat GPT. Which I think goes to show that at this point in time, they are anticipating all these changes within the technology sector. And that is obviously a good thing. But there are other companies that we have where I think we buy them precisely because we don't anticipate much change. So, there are other industries which are characterised by much more stability, and that provides greater visibility. I think that's generally quite visible. So, you know, we have Unilever, for example, in the portfolio, which has, you know, a variety of brands that have been around for many, many decades, if not centuries. So, I just mentioned to you, Joe, that I was just up in Liverpool last week, seeing friends and family. And when we were there, we nipped over to Port Sunlight which is over in the Wirral, and Port Sunlight is the model village that was built by the Lever Brothers over 100 years ago to provide housing for the workers of the Levers soap factory. So, you know, this is a great example of a company whose heritage goes back well over a century. And a lot of the brands that they have today are still brands that were around 50 years ago, 100 years ago. And it's incredible, actually, if you look at the sort of the leaders in the consumer staples space, for example, the stability there is actually really quite extraordinary. And I think that's one of the reasons why companies like that do have a role to play in the portfolio, even if the sort of growth these days is quite low. They do have that sort of lower risk profile that comes with knowing that those sectors tend to change at a less fast pace.

JL: Is there such thing as a culture within a company?

JB: Difficult question to ask and you would have to say that there are clearly companies that have a culture of success. There’s serious, you know, there are obvious governance structures that you would look for that would be applicable, but I think quite often you're talking about companies that are absolutely enormous, which have tens, if not hundreds of thousands of employees. And whilst we’d always look for a good manager and a good management bench, it can be quite hard to define. I mean, I'm sorry, I'm not wanting to just dismiss what's a very good question, but in some ways you want companies that you think just by dint of what they do and what has already been built will prove to be very, very resilient in the future, sort of no matter what. I can't remember precisely who said it, you know, you want a company that could be run by an idiot, because probably one day, it will be. I think that's a sort of a bit of an exaggeration, but you do want companies that would be resilient, no matter what happens to the leadership team. So, probably like with our investment trust, you'd want to know that it would continue to flourish if I, or Christian, got hit by a bus, and I think you also have the same at the companies that we look to invest in. You know, by and large, we would regard their management teams as great assets, but in most cases they won't be around forever. And we ‘re generally thinking about companies on a sort of, you know, multi-year, multi-decade basis. So, it's very unlikely, for example, that the CEO of Microsoft in 10 years' time will be the same as it is today. So, you do look for a culture of success, you do look for good management, but at the same time, you want a company that has a market position, that is so strong that it can survive if that management team changes.

JL: Well, that's a pretty good point to end this podcast. Thank you very much, Julian. That's Julian Bishop there, the portfolio co-lead of the Brunner Investment Trust. Just a reminder that any and all revenue forecasts are based on the Bloomberg consensus view. And that's all the time we have for this episode of Connected Investor. Make sure you're subscribed to the Connected Investor wherever you get your podcasts, so that you don't have to go hunting for it next time. And thank you all for listening. We value your views, and we're keen to know what you think. So do get in touch. You can contact us via the website www.brunner.co.uk. And if you could also leave a review and give us a rating wherever you get your podcasts, so that we can learn for the next time, that would be great. From Julian Bishop and me, Joe Lynam, ta ta for now.