The Essence of Equity Investing Is Owning Good Businesses
http://www.ustrust.com/ustrust/html/knowledge/WealthManagementInsights/InvestmentConcepts/owninggoodbusiness.html
by Frederick B. Taylor, Vice Chairman and Chief Investment Officer

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At U.S. Trust, we put a great deal of time and effort into finding good businesses to invest in, as we believe that they are the bedrock of any well-structured portfolio. Our conviction that owning good businesses is the essence of equity investing is rooted in how we view stocks.

There are two basic ways to look at stocks: as commodities or as securities representing individual businesses that vary dramatically in quality. Those who view stocks as commodities do not distinguish among companies. Their primary investment decision involves only asset allocation: what portion of their portfolio should be comprised of stock, not which individual stocks to own. Their goal is to equal the performance of the market, so they simply own a representative sampling of the market, ignoring the underlying quality of companies they buy.

In contrast, when we buy stocks for client portfolios, we are buying a piece of a business for them, and we never invest in the stock of a company unless we would be willing to own the whole company at the current stock price. We firmly believe that some businesses are better than others. Good businesses consistently generate superior financial performance and produce better total returns for investors. We think that through rigorous analysis it is possible to identify these businesses and to seek to outperform the market by owning them over time. Owning good businesses over the long-term is also extremely tax-efficient, an important consideration for most individual investors.

We want to own what we believe to be the best businesses we can and let their managements work for us, but the search is often difficult. Identifying a good business before other investors recognize it produces the greatest rewards, but to be ahead of the curve—to spot "emerging" good businesses—is especially challenging. Even established good businesses can be hard to find.

We are convinced that the single most important characteristic of a good business is that it produces strong cash flow and that it reinvests these cash earnings in the business at a high rate of return—generally over 15 percent and often more than 20 percent annually. As investors in good businesses, our clients should benefit from having their equity capital grow, reinvested at profitable rates of return year-after-year. The power of compounded growth in a rising market is enormous—five, 10 or 15 years of untaxed value appreciation from ownership of a good business is the core of long-term portfolio performance.

The beauty of owning a good business is that you benefit from having a smart, savvy management working for you, anticipating and adapting to economic and market changes that you would be hard-pressed to capitalize on. Good managers are better able to manage through difficult times and to determine the most attractive opportunities for growth. Ultimately, the strength of a company's management is likely to be reflected in its financial results and is evident to everyone. In seeking to find undiscovered good businesses, we look for a number of traits in the managements of the companies we own. Good managements:

• Have a long-term vision for their business and have plans to implement it.
• Realize the inevitability of change and adapt quickly to shifting fundamental and competitive conditions. They also take advantage of technological advances faster than competitors.
• Develop strong market franchises for their products or services and maintain their leadership by creating new products or services and by improving the value or expanding the markets of existing ones.
• Maintain low-cost producer/supplier status in the market, stressing continuous cost control and delivering the best value to the marketplace.
• Decentralize authority so that operational decisions are made quickly and close to the marketplace.
• Foster good employee relations and attractive working conditions. Their long-term incentive compensation systems are tied to company performance and reward employees with stock ownership.
• Practice "creative destruction," eliminating underperforming businesses and investing in more promising ones.
• Put the long-term enhancement of shareholder value first.

Good businesses can be found in almost every industry, although they are most likely to be found in dynamic, growing industries and markets. Our framework of investment strategies and themes is designed to uncover good businesses, be they transaction value, problem/opportunity or early life-cycle companies.

While our objective is to invest in good businesses for the long term, it is also important to be constantly evaluating the businesses we own and to sell them when we believe they are no longer good businesses. Usually this happens when management fails in one of its key responsibilities: anticipating major changes in the company's operating environment. Under those circumstances, even the best business is likely to falter.

So our mission is easier to say than to do. We seek to build portfolios of good businesses. We are always checking up on how well they are doing and adding new discoveries when we find them.