At AMP Capital, we consider an exceptional company to be one which persistently and reliably creates wealth over the long term.
In our view, there are two elements that define an exceptional company, the first is the ability to produce a high and enduring economic profit (a profit that comfortably exceeds the cost of capital) and second is the opportunity to expand that economic profit reliably and over a very long period of time.
Exceptional companies tend to be characterised by the following attributes:
- enduring and difficult-to-disrupt competitive advantages
- disciplined and value-adding capital allocation and
- stable long-term structural pathways to growth.
Crucially, we believe all three of these attributes must be present and aligned in order to be classified as an exceptional company.
Using a driving analogy, if competitive advantage is the ‘driver’s licence’ that permits the production of a high and persistent economic profit, then capital allocation is the way in which management chooses to ‘drive’ (drive badly and the licence will be withdrawn). Pathways to growth are the ‘fuel’ that feeds the wealth creation engine and enables the economic profit derived from competitive advantage and capital allocation to expand over time.
By identifying and investing in exceptional companies, investors have the building blocks of a portfolio that supports stable, solid wealth-creation and the compounding of cash flows to which absolute long-term shareholder returns are closely correlated.
Competitive advantage is the ability of a company to generate superior, persistent and protected cash flows over and above the cost of capital, both in good times and in bad, and over a long period of time.
Examples of competitive advantages include pricing power, barriers to entry and exit, switching costs, intellectual property, scale, technological advantage and network effects.
Capital allocation is the way in which a company divides its cash flow between its business functions.
The ability to do this wisely with an eye on the long term– either to reinforce the economic buffer of a company, to extract profitable growth or return to shareholders – is a foundation for being classified as exceptional.
While growth can come from a number of sources, pathways for growth describe enduring and non-cyclical growth tailwinds, which increase the rate at which excess returns can be reinvested and compounded over the long term.
Pathways to growth are more structural in nature and consequently less sensitive to macroeconomic conditions. Examples include the shift from online computing to the cloud, the gradual displacement of laparoscopic surgical procedures with robotic surgery or the replacement of synthetic food preservatives with natural ones.
Risk and exceptional companies
From a risk perspective, we consider an exceptional company to be one that can be relied on to preserve and grow its cash flows over time and in most operating environments.
Benefiting from high or improving economic returns, exceptional companies typically display better-than-average operating metrics and are less reliant on outside capital (or leverage) to generate healthy cash returns on equity and reinvest for their future growth and prosperity.
Very few companies around the world have all these qualities in sufficient quantity to be investable for the long term, but when they are found it makes sense to back these rare finds with suitable conviction.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.