Insights
Focus on Growth Equity: Quality
This is the first in a series of more in-depth papers that will provide a deeper insight into our Growth Equity team’s investment philosophy and process.
Introduction
This is the first in a series of more in-depth papers that will provide a deeper insight into our Growth Equity team’s investment philosophy and process. While there are several paths to success in investing, we firmly believe that ours is more reliable and carries lower fundamental risk than others. We know that success rarely follows a straight line, particularly in investing, and that we will go through dry spells together. We thus hope that helping investors develop a deeper understanding of our approach will help us through such periods.
We like to describe our investment philosophy using the acronym “QGV”, which stands for “Quality, Growth and Valuation”. Our aim is to put together a portfolio of quality companies that are growing and whose shares are trading at attractive valuations. In this first paper, we want to explain what we mean by “quality” in the investment context.
We will bring the discussion to life by referring to a concrete example: the US-based company Arthur J. Gallagher & Co. (Gallagher)1. Founded in 1927, Gallagher is a global insurance brokerage and risk management company. It generates the vast majority (approx. 85%) of its sales through insurance brokerage activities, where it helps clients find the best possible insurance cover at the most favorable rates. We believe Gallagher’s brokers have extensive knowledge of the insurance market and can find customized insurance solutions for the specific needs of each customer. In most cases, Gallagher receives commissions equivalent to 10-15% of the premium from the insurance companies as compensation for arranging the coverage.
WHAT IS QUALITY?
Quality in the investment context is an abstract and multidimensional concept that can be hard to measure precisely. Finding high-quality companies therefore requires experience, fundamental research, and clear search criteria. When searching for quality, we typically focus on three key criteria in particular: sustainable high returns on capital, value enhancing capital allocation, and healthy balance sheets.
Sustainable high returns on capital
In principle, we look for companies that generate high consistent and, ideally, rising returns on capital over time. This can be measured in several ways, and we like to focus on the CFROI (cash flow return on investment) indicator in particular, which helps normalise for differences in accounting and capital structure between companies.2
A first look at Gallagher’s CFROI history shows us that this company has generated returns on capital significantly above the cost of capital for decades. These returns have not fluctuated excessively, and exogenous shocks such as the global financial crisis or the coronavirus crisis have had hardly any discernible impact on Gallagher’s economic development. Encouragingly, returns have actually risen slightly over time.
However, much more important than the profile of historical returns on capital is the question of whether the above-average returns on capital can also be generated in the future, and this is where a significant part of our research work comes in.
High returns on capital can be achieved in two ways: First, a company can operate a business with attractive and, desirably, increasing profit margins. Simply put, this assumes that a company retain a high and increasing share of the income it receives for selling its product or service. To do this, a company must be able to exploit economies of scale, manage inflation in input costs, and, more importantly, raise its own prices over time. In other words, companies with high pricing power can achieve stable to increasing margins over time, allowing them to generate high returns on capital.
In general, the larger insurance brokers have been able to generate consistent margin growth over time. They have achieved this by limiting expense growth to levels below revenue growth through a combination of offshoring, technology-enabled efficiency improvements, and ensuring that employee salaries lag premium growth (e.g., by setting employee sales targets above employee wage increases). Gallagher’s management has communicated a goal to continue increasing margins.
On the other hand, high returns on capital can be generated if companies must only use a small amount of capital to generate their revenues. In other words, companies with lower capital intensity generally find it easier to generate high returns on capital. Insurance brokers do not need to invest much capital in their business. They do not need factories or fleets of vehicles; their operating assets essentially consist of intangibles such as staff, customer relationships, and data, combined with some office space and IT equipment.
Returns on capital should not only be high today. In most industries, high returns on capital attract competitors eager for a share of the profits, which may lead to falling returns over time. As a result, we focus on understanding why a company may be able to sustain attractive returns on capital into the future.
In many cases, companies with sustained high returns on capital will have developed competitive advantages which limit the threat from competitors. The investment legend Warren Buffett has often drawn the apt comparison to a moat, which makes it hard for rivals to capture a castle. For businesses these moats can include having a low-cost position that others cannot replicate, customers who have high costs of switching to another provider, or intangible assets (for example, patents or brands). A large part of our analysis is therefore devoted to understanding the sources of a company’s moat, and whether the moat is growing or shrinking.3 In the case of Gallagher, the competitive advantages primarily stem from intangible aspects that are difficult to replicate in the short term: long-lived customer relationships, scale and expertise, combined with extensive data and analytical capabilities.
In addition to analysing competitive moats, another focus of our research is therefore to understand the competitive environment in which our companies operate, and seek those operating within advantageous industry structures. We like to use an industry structure analysis in the form of Michael E. Porter’s five forces model, which argues the attractiveness of an industry is determined by five key competitive forces: (1) rivalry among existing competitors, (2) threat from new suppliers, (3) bargaining power of suppliers, (4) bargaining power of customers and (5) threat from substitutes (i.e. competing products). The stronger the threat from these five competitive forces, the less attractive the industry in question is and the more difficult it is to achieve a sustainable competitive advantage. One industry structure that we like best and that is found in many companies is that of an oligopoly.4
An analysis of the insurance broker market using the five forces model shows us that this is quite an attractive industry. Although there are lots of brokerage firms, the top 10 represent more than three quarters of industry revenue, and it is hard for new entrants to gain the data and capabilities to serve the complex needs of anything beyond the smallest business clients. We generally also find that market shares within market niches (e.g. reinsurance, terrorism coverage bought at Lloyds of London) is relatively concentrated, reducing competitive rivalry. The bargaining power of customers is low, as they are highly fragmented, reliant on their broker for advice, and encounter costs in switching to another broker who doesn’t fully understand their needs: this explains why customer retention rates in the industry are very high at above 90%. The fragmented insurance industry limits the power of suppliers. The complexity of the advice required means the threat posed by competing products (such as AI) is low for all but the smallest business clients. Overall, the insurance brokerage market scores well through the lens of Porter’s five forces.
Value enhancing capital allocation
It is not only crucial that a company can generate above-average returns in the long term. It is also important that these cashflows be allocated in a value-enhancing way. This could include organic business growth (for example, adding capacity in existing or adjacent markets), repurchasing shares in the company at a discount to their true worth, or judicious acquisition activity. Value enhancing capital deployment requires thoughtful management with strong capital allocation skills. Although ultimately such skills can only be assessed after the fact, we attach great importance to the track record of a management team and its incentives.
Gallagher is still a family-run company. The current CEO and Chairman is the grandson of the company’s founder. Patrick Gallagher Jr. has worked for the company since 1972 and has been CEO since 2006. Current management has sensibly deployed capital by acquiring smaller brokers at relatively low prices and integrating them into its global platform, bringing large benefits in both revenues and cost, and resulting in Gallagher group revenue growth that has averaged 11% a year for the past 20 years. While in contrast to some other family businesses, the Gallagher family today has a relatively small stake in the company: As of April 2025, the CEO owns shares worth about USD 370 mn, and there is no dual-class structure. Nonetheless, it seems unlikely that management will do things that harm the long-term prospects of the company for short-term benefits.
Healthy balance sheets
We also attach great importance to the balance sheet of “our” companies, paying particular attention to the level of debt. Businesses with sustainable business models and low operating volatility can generate a higher return on equity by partially funding themselves using debt. It may also make sense to tolerate a higher level of debt in the short term for strategic company acquisitions. However, as the experience of the Covid-19 pandemic showed, even high quality businesses sometimes encounter unforecastable negative shocks. Therefore, in general, we look for firms using only moderate use of debt capital, as this preserves a management’s financial flexibility even in times of crisis.
With relatively low operating variability (insurance is an essential purchase, and customers are sticky) and high conversion of profits into cashflow, Gallagher could, we expect, support a relatively high level of indebtedness. Unlike insurance companies, Gallagher did not take on underwriting risk (which brings with it exposure to natural catastrophe losses) or investment risk. The frequent bolt-on acquisitions that Gallagher undertook have hitherto resulted in a higher than average level of indebtedness compared to many of our holdings, but we have been comfortable, so far, that the consistency of cashflow generation could amply support this leverage.
Why are we so keen on quality?
Finally, it certainly makes sense to explain once again why we are focusing on high quality companies. In our view, there are three key arguments for this:
First, we are relying on the power of compound interest: high returns on capital in connection with structural growth and the ability of management to invest profits at the same high returns on capital set in motion a powerful compound interest effect from which we, as long-term investors, want to benefit.5
Second, the operating business of higher quality companies is subject to less volatility. Moreover, in times of macroeconomically induced weakness, for example, such companies can tend to benefit from the weakness of other companies, e.g. by gaining market share or buying up competitors.
Third, we are big proponents of focusing on our best ideas as investors. Constructing concentrated portfolios allows us to utilize our selection skills. In turn, focusing on high quality companies allows us to build larger positions with a high degree of confidence.
SUMMARY
In this paper, we have looked at quality as the first and most important criterion we look for in companies we evaluate for our portfolios: those operating in industries with an attractive industry structure and generating high and sustainable returns on capital. We look for businesses with competitive moats, which give us confidence that the high returns on capital will be sustained. In addition, we look for strong management teams with above-average capital allocation capabilities, and businesses with healthy balance sheets.
It should have become clear that the type of companies we are looking for are rare. Only a fraction of the thousands of companies that are publicly listed are of any interest to us. We strive to find these companies, to know them well, and then assemble collections of them into portfolios that we believe will deliver strong returns to our clients over time.
1 Securities mentioned in this document are for illustrative purposes only and do not constitute a recommendation or solicitation to buy or sell any particular security. These securities will not necessarily be comprised in the portfolio by the time this document is disclosed or at any other subsequent date.
2 A more in-depth discussion of the advantages of this metric would go too far at this point. We generally prefer it to other return metrics, as it often provides a better indication of a company’s underlying economic profitability and enables clear comparisons to be made across regions and time periods.
3 A careful distinction must be made as to which competitive advantages are sustainable and which are only temporary. Potentially sustainable competitive advantages can, for example, be based on brands and patents, network effects or economies of scale and size.
4 In economics, an oligopoly is a market form in which a small number of suppliers face many relatively small buyers.
5 Albert Einstein is often credited with the following quote, which we believe is very apt: “The compound interest effect is the eighth wonder of the world. Those who understand it earn from it, everyone else pays for it.”
