Wednesday, August 8, 2012

The Quality Enterprise, Part II

As a follow up to this previous post, here's another excerpt from this GMO white paper on high quality companies* and their stocks:

Their predictably higher profits are not quite high enough to command the attention of a market in thrall to the possibility of the next big jackpot. This has led to the systematic undervaluation of Quality stocks, which leads to their systematically higher returns over the long term.

The Quality Enterprise

Those that only give this a passing glance, treat it as just some strange but uninteresting anomaly, or worse, dismiss its merits entirely are leaving attractive risk-adjusted returns on the table (with risk defined as the likelihood and size of permanent capital loss, not beta). The approach deserves more respect than it gets but, at least based upon history, I suspect it will not anytime soon.

In any case, it's worth taking some time to more fully appreciate what is on the surface a rather simple insight.

More from the white paper:

Despite the benefits of this approach to low-risk investing, it appears that not many have the willpower to stay true to the concept. Stability is simply not exciting enough for most investors.

The least challenging part of this approach is finding an example of what GMO means by Quality. Look no further than what's inside many refrigerators and cupboards. The companies that make the leading small-ticket branded consumer products on a big scale and with robust distribution capabilities aren't a bad place to start.

What's sometimes more difficult is having enough patience to buy them on the rare occasions they become very cheap.

As I mentioned in the prior post, these days most are, at best, merely not expensive. No matter how good a business might be, what's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation.

If interested, I've included links to the following related posts.

Some of the older posts provide more specific examples:

The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

With no possibility of making a quick buck in shares of Quality stocks, there's historically been a lack interest in them until a period of market stress emerges. A temporary, even extended, lousy macro environment is, in fact, a good thing in the long run for the persistently profitable high quality enterprise. Their desirability during periods of stress makes sense, but it's not like the share prices of these businesses don't drop, sometimes substantially, during a rough patch. They certainly do (even if by a lesser amount than many others).

The relatively more stable price action isn't really what matters here though that's where most of the focus seems to often be.

More importantly, it's that their profitability is far less impacted by a substantial slowdown in economic activity. Some businesses had their profits crushed during the recent financial crisis. Others did not. (Those that did not aren't a bad place to begin the search for Quality.) If profits remain relatively healthy (even if somewhat diminished) and the balance sheet is strong, a temporarily reduced stock price is a very good thing for long-term investors.**

If anything, the strong get stronger during a tough economic period even if near-term profitability is hurt somewhat. Their relative financial health allows them to make smart moves in a downturn -- a time when the best opportunities are usually available -- that weaker businesses can't do.

Lower quality businesses, especially those with excess leverage, will see their profitability hit massively during times of economic stress. They end up on defense when the chance to make smart long-term moves should be at their greatest.

The weak get weaker.

So the defensive characteristics of Quality is very real, but the persistent profits allow them to often be fundamentally positioned very well once the economic headwinds become tailwinds. In combination, this usually leads to outperformance over a full business cycle.

The term "flight to quality" or "defensive" will often be used to describe these businesses. Calling them "defensive" isn't wrong just incomplete. Over a full business cycle or longer, for sound fundamental reasons, the best of them have tended to produce higher returns at less risk.

Some investors will no doubt continue attempting to lighten up on quality during extremely euphoric periods (trying to catch the wave), with the idea of jumping back into the quality stuff when the tide turns. Well, there's enough evidence to suggest this is one of those ideas that, for most participants, works well only in theory.
(Skilled or lucky folks -- the difference isn't always clear -- may even actually jump in and out this way with consistent success. Otherwise, us mere mortals or those with less luck require a more prudent approach.)

It's easy to forget the following:

Portfolio moves aren't just chances to improve portfolio performance, they're a chance to make a mistake. It's an illusion of control that can be expensive.

So are the added frictional costs.

When shares of a high quality enterprise are bought at a clear discount to value, and held for a very long time, returns relative to the risk can be very attractive indeed. Quality provides both offense and defense especially if bought with discipline. Yet, they're still common stocks and any individual one can get into real difficulties. In other words, there's less risk for the return achieved, not no risk.

Getting a great price usually requires a crisis of some kind. The time to buy for the long-term is usually when it feels awful. That, in some ways, may be the toughest part of investing. A calm temperament when the world seems a bit unstable is not a small asset.***

Now, paying a merely fair price for these durable high return businesses can work out just fine in the long run but likely means: 1) accepting less than spectacular or worse near and intermediate term performance, and 2) a reduced margin of safety to protect against the unknowable and unforeseeable.

Unfortunately, the window that opened (as a result of the financial crisis) to buy shares of higher quality businesses at very attractive valuations has mostly closed. Even with the best businesses, buying their shares with an appropriate margin of safety is still all-important but, as I've mentioned previously, it's worth considering this:

"If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." Charlie Munger at USC Business School in 1994

Finally, the price action of Quality stocks does have a tendency toward the unexciting. Those who invest for the adrenaline rush probably won't find the above approach to investing of much interest at all. It can be hard mental work at times, but mostly, there's just not much happening.

A substantial reserve of patience certainly doesn't hurt.

Adam

* With Quality defined as those with persistent profits and strong balance sheets. Basically, things like the great global franchises (though certainly others as well) with durable competitive advantages (often the great brands with wide distribution). It's an indication of core business economics and reveals little else. In other words, airlines have had a tremendous impact on civilization, but their business economics have been generally terrible.
** If a stock that's already selling below it's intrinsic value drops, yet profitability remains relatively persistent, that just means shares can be bought back from other owners (using the company's free cash flow over time) at an increasingly large discount. Those that sell their shares effectively surrender their portion of the ongoing profits to the owners who hang in there. Naturally, the less they are willing to sell their share of the profits the better. Intrinsic value doesn't increase but per share intrinsic value very much does. Allow that dynamic to compound over time and the benefits to long-term holders is far from academic.
*** I'm of the view that no one should invest in any stock unless they have a high level of personal conviction that the price paid provides a sufficient discount to their own estimate of intrinsic value. If an investor doesn't have that level of conviction at their disposal, they too often end up shaken out before the full story plays out, in some cases, over many years. So judging intrinsic value consistently well and how it's likely to change over time is all-important.
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