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Just Five Questions

If you own quality businesses that have bright futures, you are (or should be!) less likely to be worried in those — hopefully few — situations when times are tough. Quality companies, after all, are built to last and often emerge stronger following trying times.

So, how can we assess business quality? By answering these questions.

Simple yes/no answers are sufficient, with more “yeses” reflecting higher quality. But the exercise also sheds light on the issues we should investigate in more detail.

Does the company have a compelling mission?

Look for a company’s publicly stated purpose. The company’s motto often serves as a guiding force for management and employees. I prefer strong, inspiring mission statements.

A particular favourite of mine comes from Facebook Inc  (NASDAQ:FB):

“Facebook’s mission is to give people the power to share and make the world more open and connected.”

It’s a powerful statement of what the company wants to do! Look for the motto on the company website or the most recent annual report. If you have to look too hard, chalk it as a “no” and move to the next question.

Does the company have brand power?

Ever wondered why consumers prefer Blackmores Limited’s (ASX:BKL) vitamins over their generic counterparts? It’s good old brand power.   Successful branding can create loyalty with customers repeatedly buying products with branding they trust and admire. Superior branding allows a company’s goods or services to command a premium over near identical counterparts. And brand loyalty also opens the door for ‘brand extensions.’

Does the company have pricing power?

Pricing power refers to a company’s ability to increase prices without losing sales.  It is indicative of a company’s dominant market position. Dominance might be because the business offers a differentiated service, product, or experience. There may be brand power at work. Or, maybe, switching cost is high. Sometimes, it’s a combination of more than one of those factors.

Are there barriers to entry?

It’s also worth thinking about barriers to entering an industry. Industries such as banking, insurance, utilities, and stock exchanges are highly regulated, which allows incumbents to establish monopolies or oligopolies. Maybe a new entrant needs loads of capital to get started.

In many situations, there might be big technology barriers. For example, there aren’t that many hurdles to starting up a café. But competing against Cochlear Limited (ASX:COH) isn’t easy because of the deep technical expertise involved in making those hearing implants. And to top it, there are regulatory hurdles to jump to get a competing product to market.

Are the interests of key management aligned with shareholders?

At The Motley Fool, we are big fans of founder-run companies. Why? Because a founder, especially one who has nurtured a company from the early days to a public company could potentially cash out, buy an island and retire. The fact that they didn’t but instead chose to stick around is indicative of passion, purpose, and drive.

Consider these classic examples. Larry Page and Sergey Brin of Alphabet Inc  (NASDAQ:GOOG). At home, I’m thinking of David Teoh of TPG Telecom (ASX:TPM) and Gerry Harvey’s eponymous category-killer Harvey Norman Holdings Limited  (ASX:HVN). These founder-leaders have taken a very long view, accepted short-term pain for long-term gain, and in the process generated excellent returns for patient shareholders.

Foolish Takeaway

Earnings reports are essential tools for assessing business progress. But let’s not to get too caught up in the hits and misses of earnings. Instead, focusing on what you can learn from the report regarding big picture changes might be more rewarding in the long-term. The next time your company reports, run through the five questions above and you might just see your company in a whole different light.

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The Motley Fool Australia owns shares of Alphabet (C shares) and Facebook. Anirban Mahanti owns shares of Facebook. The Motley Fool Australia owns shares of TPG Telecom Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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