The most costly investing mistakes I've made weren't about price, they were about underestimating quality. Without quality, growth and value mean very little.
The problem is that "quality" has no single definition. Some investors focus solely on return on invested capital (ROIC), others on pricing power or balance sheet strength. I've found it far more helpful to take a holistic, quantifiable approach.
This is why I created a Jenga IP Quality Index, a 100-point score checklist with 10 equally weighted categories and 42 further sub-categories/attributes. In this article, I'll walk you through:
Benefits and drawbacks of quantifying the business “quality”
Overview of the Jenga IP Quality Index
The 10 quality categories
4 case studies from past deep-dived companies
Checklist features
What it is: A 100-point Quality index (10 equally weighted categories, 42 attributes)
Why it matters: Quality is half our investment equation
1. Measuring quality, the benefits and drawbacks
Quality, to me, is the size of a company’s moat. In other words: how hard is it for rivals to erode its profits and cash flows? Although this is subjective, in my investment equation (quality, growth, and value), quality is half of the equation.
Quality (50%) + growth (25%) + value (25%) = My Investment Equation
Each investor will develop their own method of determining the size of a company's moat or quality, and the purpose in this article isn't to assess any one style or approach. That said, I've found it beneficial to measure these in a quantifiable way for a few reasons.
First, quantifying quality helps one compare companies among their peers or, more broadly, the opportunity costs. One of the most challenging aspects in portfolio management is selecting one investment among companies in different industries and countries. Without truly developing a process of sizing up the risk/reward, one becomes more exposed to potential biases and emotions.
Second, another benefit of measuring quality is that it helps assess the scale and direction of a company's quality. Quality isn't static. Over time, companies sometimes build or destroy their moats by diversifying into less recurring or less mission-critical businesses, making significant acquisitions that worsen balance sheets and increase debt, or undergoing company culture changes.
By repeatedly measuring these, one has a better sense of the direction a business may be heading, and in the current technological and business climate, this has become very important.
Measuring quality has limitations too. Pricing power, for example, has different meanings to companies and is influenced by many factors. Second, certain factors are more important than others depending on the industry. For creative and several service-based industries, culture has a more critical role in determining the overall quality than in other industries like infrastructure or capital goods.
Adjusting for these brings additional complexity, which limits the true value of the quality score.
For investors, it's essential to understand that no single approach is perfect, but rather, focus on employing strategies that improve performance, and I believe the Jenga IP Quality Index achieves this, which I will discuss next.
2. The Jenga IP Quality Index
The Quality Index serves as my final checklist after the broader company research, and it's developed via a simplified four-step process:
The Quality Index is divided into 10 quality categories with equal weighting.
Each category has further sub-categories/attributes (2-6) with weightings dependent on how important I view them to the overall business quality case. Overall, there are 42 of these sub-categories/attributes.
I then score each of the 42 attributes out of 10 and determine the total quality score out of 100 points.
A final score >75 signifies a high moat company, 70-75 are moderate moats, 65-70 are weak moats, and <65 are no moats.
Like the Warren Buffett method, we like moats, and I generally prioritise companies with high (>75 score) or moderate (70-75 score) moat scores. The weak moat companies (65-70 score) are typically only purchased if there's extremely favourable growth (>20% earnings CAGR potential over 5 years) or valuation (purchased at half of its long-term earnings multiple).
I've placed a ban on buying companies with no moats (score < 65), regardless of valuation or growth prospects.
Next, I'll review the quality index categories with examples from past deep dives.
3. The Jenga IP Quality Index in motion
There are ten quality categories in the index:
New entry difficulty
Nature of demand
Balance sheet strength
Profit margin
Market, industry and their position
Pricing power
Value chain control
Value created for society
Culture
Test of time
These categories are equally weighted; the test of time (10th category) is just as important as pricing power (6th category), each representing 10% of the total score. However, within each category, they have various attributes (42 in total) at different weightings, and I'll map each of these in the appendix.
New entry difficulty: A measure of how difficult it is for new entrants. Favoured companies include those in oligopolistic or duopolistic market structures, those with high switching costs (regulatory, security risks) and those with a self-reinforcing flywheel (i.e., scaled economies shared) and limited funding from private markets.
“A near perfect example is S&P”
Nature of demand: A measure of how frequently customers consume or purchase its service or goods. Favoured companies include those with daily or weekly purchases, those with locked-in recurring contracts and low churn rates, and those serving mission-critical functions to their customers.
“A near perfect example is Microsoft”
Balance sheet strength: A measure of a company's balance sheet. Favoured companies include those with low debt, minimal goodwill and intangible assets, limited asset writedowns in the last 20 years and presence of durable inventory, limited off-balance sheet items, transparent and clear accounting and companies that return capital consistently through dividends and buybacks without excessive share issuance.
“A near perfect example is Kweichow Moutai”
Profit margin: A measure of how robust a company's operating margin and return on invested capital are. Favoured companies include those with >20% EBIT margins and 15% Return on invested capital through the economic cycle, lowest cost producers, margin durability during downturns and those with Selling, General and Administrative expenses (SG&A) stability across the cycle.
“A near perfect example is Hermès”
Market, industry and their position: A measure of market leadership, industry growth prospects and risks of disruptive forces. Favoured companies include those with clear market leadership, advantages of scale present in their industry and substantial growth prospects with optionality.
“A near perfect example is Visa”
Pricing power: A measure of a company's ability to raise prices through the cycle. Favoured companies include those with a clear track record of raising prices without customer pushbacks and the ability to justify these price increases with product or service innovation.
“A near perfect example is Ferrari”
Value chain control: A measure of a company's vertical integration and control of its suppliers and customers. Favoured companies include those with complete vertical integration, many suppliers and customers, with no one or two representing the majority of the cost of goods or sales.
“A near perfect example is BYD”
Value created to society: A measure of the value a company creates for its customers and broader society. Favoured companies make society and their customers happier, healthier, and more efficient with minimal negative externalities.
“A near perfect example is TSMC”
Culture: A measure of a company's overall culture, capital allocation and ownership alignment. Favoured companies include those with a strong capital allocation track record, stable management teams over the past decade and an attractive compensation structure with ownership and skin in the game.
“A near perfect example is L’Oréal”
Test of time: A measure of a company's track record withstanding the test of time over the decades. Favoured companies include those that have survived several economic shocks without losses or significant damage to their financials and have successfully transitioned from their founder with limited key person risks.
“A near perfect example is Coca-Cola” - Jenga IP analysis
These ten categories are hard-coded in my investment process, and I'm constantly reminded by each on a sheet on my table!
Bringing these categories to real application, in the table below, I highlight the Jenga IP Quality score for the six companies we have so far deep-dived at Global Outperformers.
As you can see, 5 out of 6 are classified as high moat companies (>75/100), with several of them scoring well in categories such as new entry difficulty, culture, value created for society, and profit margin. To further assess how I've arrived at each score, we'll look at four case studies, two good scores (TSMC and Alphabet) and two poor scores (Metlen and Del Sureste):
TSMC (Taiwanese semiconductor) Value created for society 9.7/10
Alphabet (US technology) Balance sheet strength 9.9/10
Metlen (Greek Industrial energy and metals) Pricing power 4.8/10
Del Sureste (Mexican airport) Nature of demand 6/10
To date, the best performing company studied internally is Microsoft with a score of 90.8/100. I doubt we'd ever come across another company with a superior quality score (I'm taking suggestions in the comments).
Case study 1: TSMC Value created to society 9.7/10
TSMC, the market leader in making the most advanced chips, plays a crucial role in today's civilisation, and among the companies I've reviewed in depth to date, only Microsoft (9.4/10) and ASML (9.7/10) come close to its score here. Measuring the value created for society is somewhat subjective, but the three attributes are:
Value created for society (4% weighting): 10/10
Externalities created for customers (3% weighting): 10/10
Rival’s ability to match value creation (3% weighting): 9/10
TSMC's key value creation lies in the efficiency and innovation power created for customers. Apple, Nvidia, Qualcomm, AMD and almost all major technology companies rely on TSMC as a crucial foundry partner. Without their R&D and overall technical expertise, it would be impossible for these customers to meet current technology standards.
The only negative externality created by TSMC is its excess water and energy usage. However, to offset this, TSMC has set ambitious environmental goals to become fully renewable by 2040, accompanied by investments in several wastewater and water treatment plants over the coming years.
Case Study 2: Alphabet Balance Sheet Strength 9.9/10
Unlike value creation to society, balance sheet strength is more quantifiable and here, Alphabet, alongside Berkshire Hathaway and Kweichow Moutai, have among the most solid balance sheets globally. I split this category into five attributes, namely:
Balance sheet leverage (4% weighting): 10/10
Size of goodwill and intangibles (1.5% weighting): 9/10
Asset writedowns over the past 15 years (1.5% weighting): 10/10
Inventory nature - perishable and off-balance sheet risks (1.5% weighting): 10/10
Share issuing, buybacks and dividends balance (15% weighting): 10/10
Alphabet's cash and short-term investments position of $95 billion is more than twice the size of its total debt (including leases) of $42 billion. While its goodwill ($32 billion) is somewhat significant, it's well covered by cash. To date, it has never impaired its goodwill, with only one asset writedown: a $375 million writedown in 2014, tied to its Motorola acquisition.
The balance sheet strength provides additional comfort and scope for future investments, enhancing Alphabet's chances in the ongoing AI race.
Case Study 3: Metlen Pricing power 4.8/10
Moving to case studies with poor scores, Metlen's pricing power provides a good example. The Greek energy-to-metals conglomerate is subject to fluctuations in commodity prices, affecting both costs and revenues. Given that market forces determine these prices, Metlen has virtually no capacity to dictate prices.
Ability to raise prices without customer pushback (3% weighting): 4/10
Responses from customers on previous price hikes (2.5% weighting): 6/10
Ability to justify price increase with product improvements (2% weighting): 4/10
Rivals with cheaper products' ability to match customer satisfaction (2.5% weighting): 5/10
To offset these risks, Metlen aims to be the lowest cost provider in all of its markets and ensure it has the most vertically integrated operations in its markets.
Case Study 4: Del Sureste Nature of demand 6/10
The difficulty with investing in airports, especially those skewed towards tourist destinations like Del Sureste (parent of Mexico’s Cancun airport), is the nature of demand. While airlines seek to maximise their passenger capacity each day, the underlying traveller, has limited travel recurringness.
Frequency of customer purchases (3% weighting): 6/10
Strength of customer lock-in recurring contracts (2% weighting): 6/10
Mission-critical for customer (2% weighting): 6/10
Product rationalisation during recessions (3% weighting): 6/10
Of the 8-10 million Americans who visit Cancun each year, just a third are repeat travellers. While leisure and travel holidays are a key feature of life, they aren't mission-critical. During a deep recession, as we saw in 2008/09, these services are significantly cut by customers, leading to some lumpy demand and revenue for airports.
Final thoughts and payoffs
Quality is the cornerstone of long-term investing. As I’ve learned, misjudge it, and even the best growth or valuation story will ultimately disappoint. This is why I utilise the Jenga IP Quality index to measure moats holistically.
For premium readers, I've shared the complete breakdown of scores across our deep-dive companies and the editable checklist spreadsheet so you can adapt to your own process and weightings.
This framework has directly impacted my portfolio in the following ways:
Kering (French luxury goods): I sold after calculating it was a weak moat company, not the high moat I had assumed.
TSMC: I doubled down despite the geopolitical risks because the quality index reconfirmed its high moat status.
Evolution AB (Swedish live casino and gaming): I reduced my position when its score showed it was weaker than we thought.
Appendix
The Jenga IP Quality Index weighting
New entry difficulty (10% weighting)
Market structure - concentration of market leaders (2.5% weighting)
Switching costs - regulatory, security or mission critical barriers (2.5% weighting)
Funding from private markets for new entrants (1.5% weighting)
Scale required for success and difficulty of abnormal profits (1.5% weighting)
Self-reinforcing flywheel or presence scaled economies shared (2% weighting)
Nature of demand (10% weighting)
Frequency of customer purchases (3% weighting)
Strength of customer lock-in recurring contracts (2% weighting)
Mission-critical for customer (2% weighting)
Product rationalisation during recessions (3% weighting)
Balance sheet strength (10% weighting)
Balance sheet leverage (4% weighting)
Size of goodwill and intangibles (1.5% weighting)
Asset writedowns over past 15 years (1.5% weighting)
Inventory nature - perishable and off-balance sheet risks (1.5% weighting)
Share issuing, buybacks and dividends balance (15% weighting)
Profit margin (10% weighting)
Unit economics margins (2% weighting)
Overall company EBIT margin and ROIC (2% weighting)
Lowest cost producer and cost structure (2% weighting)
Durability of profit margin during downturns (2.5% weighting)
SG&A stability through the cycle (1.5% weighting)
Market, industry and their position (10% weighting)
Market leadership (2.5% weighting)
Advantages of scale present in industry (1.5% weighting)
Global market structure (1% weighting)
Risk of disruptive forces beyond industry control (1.5% weighting)
Addressable market, growth prospects and optionality (2% weighting)
Barriers limiting market TAM growth (1.5% weighting)
Pricing power (10% weighting)
Ability to raise prices without customer pushback (3% weighting)
Responses from customers on previous price hikes (2.5% weighting)
Ability to justify price increase with product improvements (2% weighting)
Rivals with cheaper products' ability to match customer satisfaction (2.5% weighting)
Value chain (10% weighting)
Control of its supplier to customer ecosystem (4% weighting)
Supplier concentration and ability to control their prices (3% weighting)
Stakeholders beyond customers e.g labour unions, government and regulatory risks (3% weighting)
Value created for society (10% weighting)
Value created to society e.g. happier, healthier, more efficient (4% weighting)
Externalities created to customers and society (3% weighting)
Ease of rivals ability to match value creation (3% weighting)
Culture (10% weighting)
Length, churn and performance of current management (1% weighting)
Compensation structure and incentives (2% weighting)
Overall culture reputation (2% weighting)
Ownership and insider skin in the game (2% weighting)
Capital allocation and track record (2% weighting)
10. Test of time (10% weighting)
Survived past economic shocks with ease (5% weighting)
Survived bad management or transition from founder (5% weighting)
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