Friday, August 3, 2012

The Quality Enterprise

From this GMO white paper:

...in 2004, we published our findings that investors had historically underpaid for the low-risk attributes of high quality companies. 

Later in the paper they also added the following:

The systematic valuation advantage of Quality companies is an important component of our investment thesis. While it is possible that at some point Quality could become universally overvalued, we currently view that as unlikely because so few market participants adhere to our Quality framework. Meanwhile, academia continues to promulgate Modern Portfolio Theory, ensuring a steady supply of new market participants who follow the logic that risk is necessary for outperformance.

Basically, the paper makes the case that market participants have historically overpaid for high risk and underpaid for low risk and provides solid backup for their view.

Contrary to Modern Portfolio Theory (MPT), historically the lower risk companies outperform the risky ones and the market has systematically undervalued them (the early 70s and late 90s are two time periods I can think of when many became much more than fully priced). It's an insight often not used (by pros and non-pros alike) even though the evidence to support it is not tough to find nor does it require some kind of complex analysis.
(By the way it's not exactly easy to convince someone of this. I've had modest success at best over the years. In my experience the typical response to it has been: "There has to be more to it!" Well, there really isn't.)

Companies with durable profitability, those all too frequently referred to as "defensive", provide more "offense" than market participants seem to think. These businesses just happen to do it at lower risk.

The above may trash MPT, deservedly so, but the paper strongly embraces the best ideas from the microeconomics of oligopolies.

It's that the best companies, among what are essentially oligopolies, can legally create barriers to normal competitive forces. This potentially creates above average long run returns.

Not exactly groundbreaking stuff but it just, for whatever reason, seems to be underestimated or at least underutilized. The reasons why are less important from a practical standpoint. What does matter, practically speaking, is it has historically led to mispricing on the low side.

Some may remain dedicated adherents to the competitive equilibrium model but it's either limited or totally flawed depending on your point of view. Businesses, according to that model, are destined to have their profits revert to the mean. Well, in general, as the GMO paper points out:

Oligopolies Do Not Revert

Flawed ways of thinking can be very costly.

The higher quality enterprises, those with a long track record of above average returns on capital, have a tendency to continue producing above average returns. Their profitability has been persistent with long-term effects and outcomes not as difficult to foresee as some might imagine. Of course one has to take more risk to get more return, right? Nope. There is certainly at least some evidence to support the idea that these kind of companies produce very solid returns, at possibly lower risk, over the long haul. While this may go against conventional wisdom, it has the great benefit of sound reasoning and enough evidence to make it more than mildly interesting.

There's hardly a guarantee the above will remain true going forward but, in the context of the risks one must take when investing in common stocks, it's a very useful insight.

Just about as good as one can ever reasonably expect when it comes to investing in stocks.

In other words, this promises nothing about the future. Yet it would seem to be, at the very least, not a terrible place to focus the investment process.

Unlike many of my earlier posts on this subject, I happen to think shares of the highest quality businesses are not exactly cheap these days (they're merely not very expensive).* Still, with enough patience and discipline, buying pieces of businesses with durable advantages -- especially those that are well understood by the investor and sell at a clear discount to a conservative estimate of value -- can produce long run returns relative to the risk that tend to be very attractive indeed.

I'll follow up on this in another post.

Adam

Related posts:
The Quality Enterprise, Part II - 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 any investment, no matter how seemingly attractive, margin of safety is all-important. What's sensible to buy at a price that represents a nice discount to intrinsic value doesn't make sense at some materially higher valuation. Margin of safety protects against the unforeseen real, even if fixable, business problems. Still, 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
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