Why I say ‘no’ to 99% of companies

You don’t make a great museum by putting every piece of art in a single room. What makes a museum great is what’s not on the walls. The best is a sub-sub-subset of all the possibilities. 

The same applies to portfolio management, in my opinion. 

There are thousands of publicly listed companies globally. Only 15 currently make it into the Quality Shares Portfolio, meaning I reject over 99% of the companies I set eyes on. 

So, how do I make that decision to say ‘no’? 

My ‘no’ filters

There are many reasons I might decide against investing in a company. 

Cultural concerns are a key one. If I have serious doubts about the management and/or culture of the business I won’t invest, no matter how attractive the business model.

Below, I discuss five other big ‘no-nos’ for me: 

1. I don’t understand the business

During Berkshire Hathaway’s 2024 annual general meeting, Warren Buffett (Chairman and CEO) was asked for his thoughts on artificial intelligence (AI). He responded: “I don’t know anything about AI.”

Key to Warren Buffett’s success has been only investing in companies that fit squarely within his comfort zone (he refers to this as his ‘circle of competence’). I’ve tried to do this throughout my investing career (and the times I haven’t, I've often paid the price). 

There are many business models and industries I’m never likely to understand, including most:

• Early-stage technology companies
• Pharmaceutical and biotechnology companies that live or die by the success of their drug pipelines
• Banking and insurance companies with complex (and subjective) accounting

It’s also why I stick to investing in the UK, North America and Europe. I avoid markets with cultures, politics, and accounting regimes that I am unfamiliar with. 

I’ve learned that If I’m trying too hard to convince myself I understand something, it’s probably a sign that I don’t. There are no medals for investing in the complex and esoteric. Better to move on and find something more within my sweet spot. 

2. The company is a ‘price taker’ 

A ‘price taker’ is any company selling a product or service where price is, by and large, set by market forces beyond its control. 

For example, the revenues of an oil company or miner depend largely on oil and commodity prices. Motor and home insurance prices depend mainly on market supply and demand. While housebuilders’ revenues will always be tied to house prices. 

Being a ‘price taker’ doesn’t necessarily make a business a bad investment. But it does mean it probably isn’t very predictable, nor overly in control of its own destiny. 

By contrast, pricing power confers resilience and predictability to a business, as well as offering some inflation protection. It is typically bestowed on companies providing critical, but low-cost goods or services, with few alternatives.

Take industrial distributor, Diploma, held in the Quality Shares Portfolio.

An industrial seal for a piece of construction equipment supplied by Diploma might cost only a few dollars. But if that seal breaks, work grinds to a halt. Every day the machine lays idle costs the user dearly, both financially and in lost time. 

This means next-day delivery and having the right seal in stock matter much more than price. Diploma excels in both. This lends pricing power and is demonstrated by Diploma’s strong and rising profit margins, despite inflationary cost pressures.

Diploma operating margin (%)

3. The company’s balance sheet leaves it vulnerable

Investors often don’t pay as much attention to the balance sheet as they should, in my opinion. Perhaps this is because they have quite short memories.  

A long period of record low interest rates following the 2008 financial crisis meant financing was cheap, plentiful and apparently risk-free. The Covid-19 pandemic reinforced the notion that balance sheet strength is not that crucial. Debt markets functioned well, governments responded with large stimulus packages and equity markets staged a rapid recovery. This meant most companies needing to refinance or raise money could do so quite easily. This seems to have lulled investors into a false sense of security, despite the significant rise in interest rates recently.

The 2008/09 financial crisis was different. 

Banks either couldn’t or wouldn’t lend, so debt markets seized up. This meant balance sheet strength was critical. Companies that lacked it either went bankrupt (like Lehman Brothers and Northern Rock) or had to raise money from shareholders at deeply discounted prices, like housebuilder Taylor Wimpey, leading to destruction of shareholder value.

Taylor Wimpey's share price performance in 2008

So, I spend a lot of time analysing balance sheets – not only the amount of debt, but the way it is structured, to try and protect my downside.

I judge each situation on its own merits. A company operating in defensive end-markets, with a high proportion of recurring revenues, limited covenants and long-term debt maturities should be able to comfortably shoulder higher debt levels than a company with the opposite characteristics, where even a small amount of debt could pose a substantial risk. 

The key test, ultimately, is: will the company’s balance sheet allow it to weather a market downturn, and emerge stronger? If I think the answer is ‘no’, I won’t invest, no matter how attractive everything else looks.

4. The company lacks a ‘moat’

In my experience, the biggest threat to a company’s ongoing relevance isn’t a lack of growth opportunities. It’s competition. 

It’s why, in my opinion, Zoom Video Communications couldn’t live up to the hype. 

In theory, the pandemic was a massive boon for Zoom, leading to a huge increase in its addressable market. But Zoom was a sitting duck for Microsoft Teams, with little to prevent customers from jumping ship. The subsequent share price performance of Zoom says it all. 

An economic ‘moat’ helps protect a business from competitive attack. It can come from strong brands, switching costs or networks effects (a business that gets stronger with more users), for example. Whatever the source – every company I invest in must have one. 

And the truth is, most companies don’t have much of a moat. It’s why restaurants, bars, retailers and gyms are almost invariably terrible businesses to invest in. These markets may be large. But there are no barriers to entry, and little to differentiate one operator from the next. 

I don’t just look at the size of a company’s economic moat, but also the trend. Is it getting wider, narrower or staying the same? 

The internet, social media, and the ability to outsource production have opened the playing field to smaller, more agile players, across a range of industries. It’s why companies like Unilever and Reckitt Benckiser are having to work harder to grow sales and margins. They still benefit from strong brands, distribution networks and scale advantages; but these arguably aren’t as strong as they once were (their moats have narrowed). 

I want to invest in companies with, at the very least, strong and stable moats; and preferably widening competitive advantages. Most companies don’t cut the mustard. 

5. The company has very high capital requirements

I dislike businesses that have to spend lots of money just to stand still. Utility companies are a prime example.

In the year to March 2024, BT Group spent around £5 billion to maintain and upgrade its infrastructure. This compared to free cash flow (the cash leftover after deducting costs like interest and capital expenditures) of c. £200 million. If you include pension deficit payments of c. £800 million, free cash flow was negative. 

Every year water and electricity companies spend fortunes on keeping water flowing and the lights switched on. The returns on this spending are invariably modest because they are set by regulators, who cannot be seen to offer consumers the raw end of the deal. And there is no let-up – they cannot decide to have a year off.

This is why I favour businesses with intangible assets, like brands and software, rather than physical ones like telecoms, water and energy infrastructure. It means they don’t need much money to grow, freeing up cash to for genuine growth projects, shareholder returns or debt repayments. 

Put simply, companies with low capital requirements tend to have more flexibility. When they do choose to invest, it’s normally because they see the prospect of attractive returns, rather than being ‘forced’ into it by the nature of their business model. 

By contrast, capital-intensive companies are often caught in a vicious cycle of spending, for marginal benefits, while being loaded up to their eyeballs in debt. I lose no sleep avoiding them.

The importance of discipline (and why it’s tricky)

Saying ‘no’ to businesses isn’t as easy as it sounds. 

‘Fear of missing out’ on opportunities, a desire to follow the herd, falling in love with an idea based on first impressions, and buying into a good story can all tempt investors to stray from their investment principles.

This is why discipline is critical.

I lean heavily on my 60-point checklist when assessing businesses. It’s designed to raise red flags in the business model and culture early on, before I have ‘mentally committed’. 

It doesn’t prevent mistakes (I’m yet to find anything that does). But I like to think it helps keep me on the straight and narrow. Above all, it enables focus, freeing my time and energy for the companies I deem exceptional, while allowing me to ignore pretty much everything else.