One of the issues with "quality" is that it is impossible to define in an all-encompassing framework. There will always be idiosyncrasies and nuances with every business and industry that cannot be captured by a framework. That said, there are certain high-level characteristics that quality businesses have in common.
Business Quality Framework
Central to any business is the value it provides to its customers. If a company does not provide real value to its customers, then eventually they will find alternative solutions, even if the barriers-to-entry are strong. Maintaining a superior value proposition requires reinvestment and improvement in a way that customers actually want — i.e. innovate but don’t over-innovate. Sometimes companies over-innovate, unnecessarily increasing their cost base when some of their customers do not value it, creating a price-umbrella for competitors to enter the market. Gillette razors and the Windows phone come to mind here.
It requires understanding when certain attributes become 'good enough' in the customers’ eyes such that the axes of competition shift — e.g. when performance is satisfied, customers often look to other factors like aesthetics or price. It can be powerful when a company’s value proposition is also a key structural competitive advantage ("moat") and when it is reinforced with scale (e.g. Amazon’s cost advantage is reinvested into the value proposition in the form of lower prices; Facebook’s network is both the value proposition and the moat).
Competitive advantages (“moats”) have two dimensions — advantages versus competitors and advantages versus the value-chain (e.g. suppliers and customers). They come in a variety of forms but only a few are sustainable over the long-term. Some examples include economies of scale, switching costs, network effects, intangibles, data, innovation processes, and advantaged cultures. We do not rely on things like a product advantage or a first mover advantage. Without something more, such things are not structural and sustainable. The best competitive advantages continue to strengthen as the company scales. If the mathematical compounding of returns is the Level I of compounding, the ability to re-invest earnings at attractive rates of returns is Level II, and the deepening of the moats from this growth is Level III. A quality business has all three.
We spend a lot of time understanding the deeper layers of these advantages. For example, it is not enough to simply identify a 'network effect' — we want to know how the network works, which parts of the network can be replicated, whether it is an exclusive network, if the underlying value proposition of the network can be satisfied through alternative non-network business models etc. We want to understand how the competitive positioning is evolving over time. We never conclude “this is a great business” but rather “this is a great business in the current industry context”.
We are wary of businesses with a single advantage, especially if this is a scale advantage or customer switching costs. Scale advantages are vulnerable to competition from well-capitalised incumbents in adjacent industries. Switching costs might help retain customers but they don’t help capture new customers and drive growth. They also typically annoy customers.
We are also wary of management teams that abuse their competitive advantages to the point they fail to reinvest in the customer value proposition or they become too extractive toward their customers or suppliers. A healthy and sustainable value-chain must be properly incentivised. We only invest in businesses where customers “want to”, not “have to”, use the product or service. Providing value is what truly sustains a business; competitive advantages just make it a easier to do this versus the competition but they are nothing without a strong value proposition.
Companies with high fixed costs can amortise them over a larger and larger revenue base (demand-side scale), thereby improving operating margins over time. This affords the company a cost advantage versus competitors and allows the company to spend a greater quantity of dollars for the same percentage of margin in areas such as research and development (“R&D”), marketing, or plant and equipment (i.e. asset utilisation) etc. The favourable amortisation of fixed costs as revenue grows is called “operating leverage”. On the flip side, it can be damaging when revenue contracts. Operating leverage can be as risky as financial leverage in some cases.
While operating leverage is valuable, economies of scale extend beyond this first order effect. Scale may help a company become more efficient overall. For example, greater access to capital equipment, specialisation of teams, bargaining power over suppliers, spreading of risk, reduced borrowing rates, synergies, cross selling, bundling etc. These are supply-side economies of scale. Economies of scale may also reinforce the value proposition through greater innovation or if the company reinvests the advantage into lower prices, creating a virtuous circle.
Overall, moats stemming from economies of scale on their own are not the most sustainable moats. This is especially true for demand-side economies of scale. Well-capitalised entrants with cheap funding sources may buy scale to compete. For example, Disney’s acquisition of Fox/Hulu made it a significant scale competitor to Netflix. However, economies of scale combined with other moats can be very powerful. Further, some businesses may have diseconomies of scale. For example, the business may become too complex to manage, returns can be diluted, the business may become less nimble, or the core business may prevent its ability to shift and compete when the market changes.
In some businesses, it is costly for customers to switch suppliers. Broadly speaking there are three types of switching costs — financial (penalties for breaking a contract etc), procedural (related to business disruption), and relational (interpersonal relationships or personal relationships with a brand etc). For example, software or systems that are linked to many aspects of a business’s internal processes, such as customer relationship management or enterprise resource planning software, may require significant effort to replace. This can increase the customer acquisition cost for competitors, particularly in saturated markets where most new customers are already being served.
Customer switching costs are not additive to the customer value proposition. Relying on these alone without offering real value to customers risks leaving the customers frustrated and eventually they will find alternatives. For example, this may be the case for fund administrators whose systems are often outdated due to lack of investment causing great frustration to clients. Further, customer switching costs do not provide an advantage when competing for new customers so they are less useful in a company's early growth phase.
Some business models utilise a network of customers and/or suppliers. A network effect exists when the value of that network to any individual member of the network increases as the network expands. For example, the value of Facebook to an individual is low when there are only 100 users but high when there are over 1 billion users. There are many types of networks — some examples include homogenous (one-sided) vs heterogenous (2-sided or more), unidirectional versus multi- directional (direction of value transfer), open versus closed, or protocol networks (where a set of standards helps coordinate users, such as market benchmarks like the S&P 500 or regulatory standards). Strong network effects make it hard for new networks to compete as incremental members would prefer to join the higher-value existing network.
Very strong network effects can lead to a winner-takes-all market structure where it is extremely difficult for new entrants with similar business models to compete. However, a key risk is that competition comes from alternate business models that don’t require the same network. For example, eBay had strong network effects as a marketplace and operated in a very strong position in online auctions in the US. However, Amazon’s business model was so successful in driving efficiency for new products that it impacted both eBay’s new and used products business. Another example is Uber. It operates in local monopolies or duopolies due to the strong network effects that drive better asset and driver utilisation. This makes it very hard for new ride hailing and sharing platforms to enter their markets. However, they are heavily impacted by other business models such as food delivery given that they compete heavily for the same labour pool. Another key vulnerability is the existence of a value-proposition or customer set that is not being served adequately by the existing network. For example TikTok and SnapChat address a different value proposition and demographic set than Facebook/Instagram.