Finding Quality Compounders

How to find high-quality businesses (without a stock screener)

Picture by The J. Nicholas (original author)

Hey investors 👋,

Welcome to today’s Deep Dive.

Today, I’m excited to kick off a Deep Dive preview series, where I’ll cover each of the main chapters from my upcoming eBook, How to Analyze Stocks… (name change is possible). The goal of the eBook is to teach you how to find, analyze, research, value, and profit from high-quality stocks—step by step. A contrast to what my Stock Analysis posts aim to accomplish—which is to do the research for you, and provide actionable insights. Both resources are incredibly valuable.

I’m writing this series with the assumption you as the reader already understand the basics of stocks and the stock market. If you find things you don’t know, you can always view my older posts on Blossom, or email me about what you need help with, and I’ll send over some great resources to help you learn. The paid stock analysis eBook, and the free beginner one, will be released together.

In this series, I’ll walk through every key step of the stock research process, starting today and continuing over the coming weeks. Why am I making this a free newsletter series instead of waiting for the paid eBook? Simple: so all of you can access the content, even if you don’t pay for it. The paid eBook, when finished, will be a more consolidated and researched version of this series—a detailed one-stop shop. Paid subscribers will receive this paid eBook, free.

To start off the series today, we’ll answer one of the most common questions I get: How do you actually find quality stocks to invest in? That’s step one in the research process and the focus of the first chapter in my upcoming eBook. And great news, this is also the “easiest” and shortest step.

Let’s get into it. (14 min read)

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Today at a glance:

1. How to find

2. What to look for

3. Tools & resources

   (optional, but useful)

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How to find

I’ve never once used a stock screener to find the high-quality businesses I own or decide to write about. Most times, I just hear about a stock (controversial, but true), see something online, look on the back of items in a store for a company name, see company names as I drive around, or just think about the products I use on a daily basis. Other times, I scroll through the largest list of companies in the world as a pastime. (I’ve done that a few times.)

Is this an efficient way to find companies? Probably not. Is it effective? Absolutely.

Most of the current largest and most influential companies are publicly traded. In my eyes, one of the most effective ways to find a stock is to simply analyze your life and the products you use consistently; pinpoint the brands that own those products, find the parent companies of those brands, and check if that company is publicly traded. I did the same for myself for this post, and here’s the list of products I’ve used over the past week and their respective parent company in alphabetical order:

• Amazon – Prime, Alexa

• Apple – iPhone, Mac, iPad, etc.

• Bath & Body Works – Fragrances, soaps

• Beiersdorf Global – Nivea (skincare)

• Berkshire Hathaway – Fruit of the Loom

• Bloomberg – Financial news

• Blossom – Social platform

• Canva – Graphic design

• CIBC – Banking services

• Cineplex – Movie tickets, snacks

• Coca-Cola – Beverages

• Costco Wholesale – Bulk groceries, household goods

• Dollarama – Household items, snacks, stationery

• Empire Company – Groceries

• ExxonMobil – Gasoline, lubricants

• Gap (Old Navy) – Clothing

• Google – Gemini, Gmail, Search, Docs, Sheets, YouTube

• Hyundai – Car

• Imperial Oil – Gasoline (Esso)

• Intuit – Mailchimp

• Kenvue – Tylenol, Band-Aid, Aveeno

• Kimberly-Clark – Kleenex (tissues)

• Kraft-Heinz – Ketchup, snacks

• La-Z-Boy – Furniture

• Loblaw – No Name products

• L’Oréal – Skincare, haircare

• Mastercard – Credit/debit transactions

• Mitsubishi Pencil – Pens

• Netflix – Entertainment

• Nestlé – Coffee, chocolate, bottled water

• Nike – Shoes, clothing

• OpenAI – ChatGPT

• Parkland Corporation – Fuel (Chevron, Pioneer, Ultramar, etc.)

• Patreon – Subscriptions

• PepsiCo – Chips, beverages

• Permira – Boots

• Power Corporation of Canada – Wealthsimple

• Procter & Gamble – Tide (detergent), Bounty (paper towels), Crest (toothpaste), Oral-B (toothbrush)

• Renault-Nissan-Mitsubishi – Car

• Restaurant Brands (Tim Hortons) – Coffee, food

• Rogers – Mobile or internet service

• Samsung – TV, fridge, dishwasher

• Shell – Gasoline, motor oil

• Skechers – Shoes

• Spotify – Entertainment

• Stellantis – Car

• Substack – Newsletter, Notes

• Suncor Energy – Gasoline (Petro-Canada)

• TD Bank – Banking services

• Telus (Public Mobile) – Mobile or internet service

• Tencent – Discord

• The New York Times – News, articles

• Thomson Reuters – Reuters news

• Unilever – Condiments, personal care

• Visa – Credit/debit transactions

• Walmart – Toaster, Great Value

Out of these 56 companies, ~51 are publicly traded. And the crazy part? I’m probably missing hundreds more. The even crazier part? This isn’t including the companies I indirectly give my money to when I buy from these companies or use their products. For example: Apple sells electronics, but those electronics are able to be sold because Apple paid other companies for their products and services, to build out the finished product.

Still with me?

The screen, chips (semiconductors), cameras—whatever it may be—it’s not all made by Apple; it’s made by a seperate business. Just for the iPhone, here’s the large (and probably incomplete) list of companies involved in making your overpriced Apple smartphone whole:

• TSMC

• LG

• Samsung

• Texas Instruments

• SK Hynix

• Micron Technology

• Sony

• CATL

• Amperex Technology

• Qualcomm

• Broadcom

• Skyworks Solutions

• Nissha, Corning

• Foxconn, Pegatron

• Analog Devices

• Lumentum, Finisar

• STMicroelectronics

• Vishay Intertechnology

• Bosch, InvenSense

• AMS

• Luxshare Precision

• Amphenol

We can go even further by doing the same process for each of these companies, going deeper and deeper to find more and more businesses. Even just for the companies I have in the first list. Imagine how many high-quality companies I could find by simply figuring out what companies are part of the Amazon, PepsiCo, or other supply chains or operations like Apple. That list is hundreds, if not thousands of businesses. Most publicly traded.

Many people think surface-level when they say “buy what you own” in the stock market. But going deeper, actually analyzing things—that’s where you find opportunity; doing what other people won’t. Go through this exact same thought process yourself. It’s an amazing way to find some businesses that may be high-quality. Whether on a paper notebook or in your digital notes app of choice—try it out. You’ll be amazed… at how much you overspend.

But wait—how do you know if a business is “high-quality” anyway?

Once you find the business you’d like to research, that’s the next step.

What to look for

To find a high-quality business, you need to answer a list of simple attributes. (Not all need to be present, but at least more than one):

• It has a recurring or reoccurring revenue model.

  • Recurring: A business that charges the customer on a consistent basis.

  • Reoccurring: A business that sells a product that the customer will buy more than once. Think of Netflix or Coca-Cola respectively for each of these definitions. Netflix is paid monthly for their service; Coca-Cola isn’t, but customers consistently come back to buy some Coke year after year (recurring vs. reoccurring). This makes the business much more resilient in economic downturns or the like. The more formal way of saying this would be a “repeat purchase model.”

• It has stable, consistent financials.

  • (Self-explantory.)

• It has a stable competitive advantage.

  • A market share advantage (Amazon, Microsoft, Nvidia), brand power advantage (Louis Vuitton, Coca-Cola, Nike), high switching costs advantage (Salesforce, Bloomberg), network effect advantage (Uber, Meta, Airbnb), and exclusive contracts/patents, etc., advantage (Boeing, Lockheed Martin, Pfizer). (There are some companies that hold more than one of these advantages—such as Apple—which holds the brand advantage, network advantage, and market share advantage in certain geographies. This creates the absolute monster of a business Apple is.)

• It has smart capital allocation.

  • This refers to how good a company is at deploying its available cash to generate long-term value and maximize returns for shareholders. This can be thought of as a prerequisite for an amazing management.

• It has skilled management.

  • A leadership or executive team that prioritizes the growth of the business, the values of the company, putting shareholders and the growth and sustainability of the business first.

Analyzing the attributes

Look at you, already almost done learning how to find a quality business! For the final step, it’s time to understand and learn how to analyze the attributes listed above to decide whether or not a business is high quality. For our example here, I’m going to use an indirect company involved with one of my original companies listed from the products used list: Texas Instruments, the supplier of analog chips to Apple.

Texas Instruments is a hardware technology company that manufactures and sells mainly analog semiconductors. In fact, over 80% of the company’s revenue comes from just analog semiconductors.

Analog semiconductors can be thought of as a sort of traffic controller inside electronics that ensures things work smoothly. It’s the chip in your iPhone—or smartphone generally—directing the other components in the iPhone’s hardware to do what it needs to do. That’s the heavily simplified version at least. Texas Instruments (TI) controls 17-20% of the global analog semiconductor market. Some sources say this places it as the largest player in that space, while others put TI and Analog Devices (the main competitor to TI) as very close leaders. For simplicity in explaining, I’m going to assume TI is the leader.

Companies like Apple don’t buy these chips from TI and use them in one iPhone series and not buy them again; the products TI sells fall into the reoccurring business model. While the customer isn’t purchasing on a recurring basis like with a subscription, they purchase annually as new devices are released. The newest iPhone needs these chips in the phones, as do stoves, cars—anything with a screen or electrical component.

TI has mainly a market share advantage with a reoccurring business model. Most of the businesses TI sells to, it has partnerships with, that include lengthy contracts with the company. Not all customers, but many. This adds another competitive advantage: a strong brand (long-term familiarity) and a contracts/partnerships advantage. From what I know from my surface-level research for this section, TI’s product is broader than its closest competitor, Analog Devices—which does give it an advantage in the industry.

To finish this quality analysis, we need to dive into the financial statements and listen to earnings calls from at least the past four quarters. From this, we’ll be able to decide if the capital allocation and management quality… are high-quality.

Looking at financials, we start to see an immediate problem with the consistency. Revenue year over year ebbs and flows heavily, the same for cash flows, and much worse for earnings. Profitability has been sinking over the past five years, and revenue growth has been dropping. This is mainly due to the cyclical nature of the semiconductor industry—meaning the industry is heavily influenced (and therefore all of the companies involved) by unpredictable supply and demand that comes with different economic cycles. When we’re looking for high-quality businesses, we need predictability. Of course, recessions happen, and that predictability will be minimally affected for all companies during those times, but we want very stable year-over-year growth in revenue and free cash flow to classify a business as high quality. We need a strong foundation, and TI does not seem to be that, in this sense.

As for capital allocation, much of TI’s cash flow has been put towards its research and development costs and high capital expenditures (capex) due to the huge demand for chips from AI in recent years. This is great news for TI when we’re talking about capital allocation, as this rise in capex and R&D—while hurting cash flows today—could mean there’s a high priority for the company to invest in new factories, equipment, and much more that bears high investment costs. This would mean the company cares about the long-term health of the business, and is not becoming too comfortable with its market position.

Consistency in dividends is also very high, growing quarter after quarter, year after year. Together, the company has a great focus on the long-term growth of the business and its advantages, but also on keeping shareholder returns—a great combination of capital management.

But for actual management; leadership, we need to read shareholder annual reports and letters, listen to earnings calls, and simply understand if the leadership of TI is following through with goals, doing as they say, reaching guidance targets often, and providing clear direction. Again, for this example, I won’t be giving that research, but I will assume for simplicity that the management has been doing the above.

Say they’ve been following goals, providing forward-thinking direction, etc. Does this altogether make them a high-quality company? No, it does not. The cyclical nature of the business ruins the predictability and consistency of the company as an investment and makes it much more susceptible to market fluctuations and economic downturns. This makes it hard to label as a quality compounder when most of the good attributes of the business (its focus on the long-term, investments, market position and advantages, good management) are outweighed by the bad attributes. According to my view on things, that is.

Broken down, these are the steps to analyze the quality of a business:

• Understand the business.

• Dissect market position and competitive advantages.

• Analyze competitors.

• Dig into the financial statements, read annual reports.

• Listen to past earnings calls.

Apply this guide to the businesses you’d like to analyze as “high quality,” and you’re all set.

Tools & resources

I’m not going to leave you empty-handed with things to streamline your process of finding a quality compounder. Before you leave, here are the sources I recommend you use for this process (not limited to):

• Quartr (iOS/Android App)

  • Listen to past and future earnings calls, read quarterly transcripts, annual reports, etc.

• Company investor relations

  • Your bread and butter. Search up any public company name, followed by the term “investor relations” to see all the public earnings reports, updates, and filings in a simple, displayed manner. If you cannot find this, head directly to the SEC EDGAR or the equivalent regulatory body in the country where the company is headquartered to find those same filings.

Google Search is your best friend with all of this. I understand ChatGPT has recently been used by many investors, and I do also occasionally ask it for some help, but it’s often not the best for accurate information (even with the new update that allows it to give sources). My experience is: Most times when ChatGPT gives a link to a source, the source it links to doesn’t back up what it claimed. At the moment, I’d be careful with using large language models/AI chatbots in your research. They can be mischievously inaccurate.

Finally, I’d recommend joining communities—Blossom Social, private Discords, Twitter, Substack, Reddit—to speed up your learning or research. But again, be very careful with what you find in these communities. Don’t take everything at face value. They can be amazing sources—Blossom is one of the best in my opinion—but everything has misinformation, so always ask for sources or double-check what you see, hear, or read.

I would also encourage you to read books/audiobooks on this topic, subscribe to newsletters, and, best of all, follow the news of the companies you’d like to research and do so often. Bloomberg, Reuters, The Wall Street Journal—these are my personal favourites for stock-related news.

And that’s it. I hope you enjoyed the first post of this series (a very short and simple one to kick things off), and I hope you stick around over the coming weeks to learn more. Thank you to my paid subscribers and patrons for your support, and thank you to all for being here. Happy finding, investor.

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Note: There are many asterisks for this post, as many people have different goals. For me, my extra determining factor of a quality business (one I’d own) needs to have specific growth of 12-15% in its cash flows. If you follow along and are a paid subscriber, I use this factor for analyzing my portfolio and writing my stock reports/analysis.

Some people may have different criteria for a quality business, and that’s perfectly fine. Investing is an art, not a science. It just requires some practice to get your style. You first need to know the basics, then continue developing the craft until you’re comfortable enough to consider yourself an artist. The same goes for investing. I’m not a dividend investor, value investor, or growth investor. I’d say I follow GARP (Growth at a Reasonable Price) and do so pretty well (a mix of value and growth), but my style is unique to me, and that’s what I write about.

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Thanks for reading. Feel free to reply to this email or comment on the web if you need anything—I always reply. If you enjoyed today’s issue, feel free to share it with friends and family.

All the best,
Jacob

All of my links here.

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