In this post, there are two factors that I will address: 1) Quality 2) and Price. In the investment world, there’s a lot of talk about quality and not enough about how much to pay for it. Even though how much you pay for an asset is the biggest factor of your future returns.
You want to invest in quality businesses at a reasonable price. Overpaying for a quality business is not a quality investment. It’s when you overpay that you get in trouble. Even if you buy the best company in the world, you can lose money if you overpay. Quality is not the equivalent of a good investment. What you pay and what you get in returns is what matters. If the market views a particular stock as a high-quality business, it’s unlikely going to be cheap and it’ll be priced for low returns. So it’s really the search for quality that has been unrecognized or unpriced by the market that’s critical.
Q3 2022 hedge fund letters, conferences and more
The “Quality” Marketing Cliche
You need to watch out for that “quality” word. You will hear it a lot. It goes without saying that quality is something we seek, whether in people, goods, services, or in investments. But in the investment business the word “quality” has been so over used and diluted that it has become meaningless. So when we seek a quality business, you have to make sure it’s not just another marketing cliche that fund managers put in their presentation.
Investment professionals will often say to just buy “quality”. “You can’t go wrong if you buy high-quality businesses”. “Ignore junk and just focus on quality stocks.” Or “quality companies lose less money in a downturn.” They will also bring up Warren Buffett to justify anything; “Buffett transitioned to quality investing from the cigar butt approach and look at how successful that was.”
You should be wary of broad generalizations like “just buy quality” that oversimplify investing into a certain thing. To focus on quality alone is not bad advice, it’s just incomplete. Quality is a good thing. But it’s good advice to an extent. The problem is not quality, the problem is overpaying for quality. If you go through fancy fund presentations, you can pick out the marketing-cliche beats the managers are trying to hit: “economic moats,” “investment opportunity,” “massive total addressable market,” “barrier to entry”, “scalable platform”.
But for all the talk surrounding quality, there’s barely any talk about how much to pay for it. And I’m of the opinion we need to think about valuation just as much, if not more, than the time spent on assessing quality.
How to Get in Trouble With Quality
Quality at any price can get you in trouble. The “Nifty Fifty” comes to mind when talking about quality and price. The Nifty Fifty was a group of 50 large-cap stocks in the 1960s that represented the best and fastest growing in America. They became known as “one-decision” stocks. That decision was to buy and let it ride. No price was too high. Buy them and hold them. Like any mania their valuation reached nosebleed level and they eventually crashed. Depending on the stock, if you held them during the crash you would have lost 60%-90% of your money. The sin: Overpaying for quality.
Microsoft is another example of a high quality company. In the 1990s their Windows and Office flagship products were on every computer in the world. Microsoft was a monopoly, made massive amounts of money, and co-founder Bill Gates was the world’s richest man. The future looked bright. The Dotcom bubble took the stock to a different orbit. Then the bubble burst. It took Microsoft 15 years for its share price to come back to their bubble height, despite growing and being profitable every year. The sin: Overpaying for quality.
Another Dotcom high-flier was Cisco. Cisco is another solid business with a high-quality moat around it. Cisco does important things like providing the technology that “makes the Internet work.” It’s been twenty three years since its Dotcom peak and Cisco is still not close to their Dotcom peak despite being profitable every single year. The sin: Overpaying for quality.
Depending on your timing, Microsoft and Cisco are two examples of high-quality companies you could have bought and not make you money for a very long time. Both Cisco and Microsoft were highly profitable (still are), with steady earnings growth and low debt. And yet many people holding them would have been in the red. The price of these stocks got ahead of themselves. Their stocks were so hot that their valuation lost all touch with reality. The mania sent them to levels that were unjustified in relation to their earnings and growth prospects. Investors bidded them up to prices that weren’t sustainable.
You want the price of a security to be cheap relative to its value, to its cash flow, to its assets, to its perceived quality attributes. Buying quality at an extremely high price is not a quality decision. If you pay too much, you will realize that quality is not going to perform as defensively as you think it would. If you overpay, quality doesn’t provide bulletproof performance. There’s limited upside if you overpay.
What is Quality?
What does quality investing really mean? What constitutes a quality business? It’s subjective. It can be vaguely defined. Quality lies in the eye of the beholder as they say.
So what factors do investors consider that constitute a high-quality stock? It’s a confluence of factors. Some focus on quantitative metrics, such as high return on capital, a low debt ratio, low capital need, steady earnings growth, profitability, and the capacity to generate sustainable free cash flow. Things that you can measure and put a number to it.
There are qualitative factors that are harder to define and to measure. These are things such as the capacity to survive a recession (super resilient business), a long runway for durable growth, high product “stickiness” (e.g. bank account), a strong economic moat, competitive advantage, lack of competition, pricing power, high margins, capital discipline, great capital allocation skills, rich re-investment opportunities, a great enduring brand, economies of scale, and exceptional management. And there’s more.
You recognize quality when you see it. But it can’t always be measured with precision. In a business, quality is a confluence of attributes. My point is you need to study the business and you need to determine what makes it great. Quality can’t just be another tick the box on the checklist and move on without thinking hard about the confluence of attributes that you think make the business great.
Once you find that high-quality business, the next questions you should ask are 1) How much is it worth? 2) How much am I willing to pay for it? Unfortunately if you do find this gem of a company, it trades at a premium, and sometimes at prices that aren’t sustainable. Only in times of distress high-quality companies trade at bargain levels. This situation usually occurs when there’s a recession, a market crash, or the company has run into some trouble. And when that happens, nobody wants to buy them.
The Price is Right
By now I think I made the point that price is the essential factor in every investment equation. Does quality warrant a price premium? Of course it does. It’s rare to find quality at a cheap price. That’s why I suggest paying a reasonable price for quality. But how much? Well that’s the art of valuation. It’s subjective. Each business needs to be studied on an individual basis.
Any asset no matter how low the quality is, can be cheap enough to be a good investment. At the right price, every asset is a buy. No matter how terrible it is, at the right price it can become a positive investment. And no matter how great the asset is, at the wrong price, you can get in trouble. Any share you buy, you have to ask yourself what you will get in return. You are looking for mismatches, a company that is of great quality that the rest of the world thinks is crappy. That’s what a great investment is.
Since I brought up Warren Buffett earlier to justify anything, I’m going to close this letter with him. Buffett once joked that “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
