Part 2 - Fallacy of Owning Quality Companies At Any Price
by Saket Mundra, CFA, MBA
The world has become slightly different in the two months since we published our last Market Intelligence, “Fallacy of Owning Quality Companies at Any Price – Part I”. As we began to question the trend of investors owning ‘quality companies at any price’, we saw the UK vote to leave the European Union, and a concurrent acceleration of this investing practice. In Part 1 of this series, we examined the first element of our thesis, namely the difference between investors’ perceived versus actual investment time horizons when investing in ‘quality companies’. In this second segment, we continue our journey to question how today’s investors arrive at the very definition of a ‘quality company’.
It is imperative to state that defining quality is more subjective than it appears. Investors deem ‘quality’ to be presence of a competitive advantage that allows the company to earn returns in excess of its cost of capital and greater than competitors. Generally, market participants try to gauge the competitive advantages of a business by looking for characteristics such as pricing power, market share, stability of earnings etc. Over the years, academics and practitioners have tried to quantify these characteristics using financial statements. In this pursuit to identify quality businesses using quantitative metrics, most investors fall back on using ratios such as return on invested capital (ROIC) and return on equity (ROE) to differentiate between a quality business and an average one. Given that it is relatively easy to calculate historical returns with these metrics, these ratios have gained substantial traction within the investment community as a means to identify quality businesses.
When we think about the challenge of identifying quality companies, we believe it may be simplistic and naive to solely rely on the above mentioned methodology for a number of reasons. One, while it is true that a business that has some form of competitive advantage should be able to earn excess returns, we are not sure that any business that earns high returns for a short period of time (5-10 years) reflects sustainable competitive advantages. The key here is sustainability, durability and longevity of the competitive position – without which the business loses its ability to earn excess returns. Hence, we now ask: what proportion of companies are able to sustain their competitive advantages and earn excess returns over a long period of time?
History suggests that given the competitive forces at play within the broad economy or a specific industry, most companies revert to mean industry returns or their cost of capital within a short period of time1. Therefore, only a handful of extremely strong businesses are able to earn excess returns for longer periods of time. We refer to the study2 conducted by Michael Mauboussin in 2007, wherein he studied the median ROIC trend of a thousand non– financial US companies ranked into quintiles based on their ROIC in 1997 for the next decade. Figure 1 presents his findings which reinforces the view that ROIC of most companies tend to revert to the mean within a short period of time.
Mauboussin went on to study persistence of ROIC for companies in different quintiles which provided little evidence that companies with high ROIC continue to earn higher ROIC over longer periods of time. For example, Figure 2 suggests that 41% of the companies that were in the first quintile in 1997 remained there in 2006. However, it doesn’t explain how much the excess returns fluctuated in between to eventually land back in the first quintile nine years later. In fact, less than half of the 41% of the companies that start and end in the first quintile stayed in the quintile the entire time. Mauboussin found that less than 4% of the total sample population remains in the highest quintile of ROIC for the full nine years of the study. This provides evidence that only a handful of industries and companies are able to earn excessive returns consistently for long periods of time, which renders the practice of using historical returns in isolation to proclaim a company as a ‘quality company’ inaccurate.
Having established that only a handful of companies are able to sustain high ROIC while for the rest, the ROIC reverts to the mean, we move forward to the second question. How are investors blessed to find these companies consistently during the current bull market? Said another way, do investors really own quality companies as they claim to?
In our view, this endeavour of identifying companies with sustainable competitive advantages is made increasingly difficult due to external factors such as shortening business cycles and increasing technological disruption. In a study conducted by Boston Consulting Group, it was concluded that the total life span of public companies have nearly halved from ~55 years in 1970 to ~30 years in 2010 (Fig. 3). The same study also concluded that the five-year exit risk for public companies traded in the US now stands at 32%, compared with the 5% risk they would have faced 50 years ago (Fig. 4). In fact almost one- tenth of all public companies fail each year currently, which is a fourfold increase since 1965.
In light of the facts discussed so far, we find it hard to accept claims of the investment community regarding being predominantly invested in companies with sustainable competitive advantages. It seems that the distinction between average companies that are benefiting from cyclical industry trends and transitory factors (such as ample supply of liquidity in the economy) versus the companies that have structural and sustainable competitive advantages is extremely blurred today. In such an environment how does one separate the wheat from the chaff?
As always, we invariably use the lens of our investment process to “Seek the Truth”. First and foremost, no investment opportunity is eliminated for being average as long as it meets the tenets of our investment process and has a favourable risk-reward. This allows us to be honest in determining that the company’s underlying business is just average and is benefiting from the current industry and/or macroeconomic environment. While doing this might seem obvious to most, it is difficult to practice given the inherent biases one develops while researching an investment opportunity. This flexibility to be truthful helps us in valuing the business as per its merits and steers us towards proper capital allocation – which in turn limits damage to the portfolio if the tide turns.
Second, we believe that determining the sustainability of competitive advantages and thereby future returns is not a task that can be accomplished by using historical trends in one or more financial ratios – how can one be sure that the past is the prologue for the future? In our opinion, this exercise requires extensive understanding of the business and awareness of any external factors that could disrupt the status quo. In order to do so, we focus on the rate of change in the business, its ability to withstand the change and periods of disruption, and the management’s willingness to adapt if such a scenario were to happen.
Two examples of stocks in our portfolios that we deem to embody characteristics of quality businesses and exhibit our thinking along these lines are Microsoft and Cisco. Ironically both companies fall under the technology sector, which is known for its rapid pace of change. For some time, both of them have faced environments wherein their core products have come under increasing pressure questioning the sustainability of not only their returns, but their business altogether. For Microsoft, it is the decline of the PCs, and for Cisco, it is the introduction of black box routers and switches at much lower costs. When we analyzed these companies, it was clear to us how entrenched their products are in the work flow of their customers and how difficult it is to abruptly stop using them – highlighting the slow rate of change in their businesses. At the time of our analysis, both companies had significant amount of net cash on their balance sheets which alluded to their ability to withstand and navigate through the period of disruption. Finally, as we studied each management’s incentives and the potential for upcoming changes for key roles within the management, we were more than comfortable to initiate a position. These stocks, and the process we applied while researching them, reflect our thoughts and process around defining and identifying quality businesses.
In conclusion, we wish to highlight that it is essential to distinguish between businesses that are benefitting due to current industry and macroeconomic environment, and the ones that truly have structural and sustainable competitive advantages. Buying the former category under the pretext of owning quality at currently prevalent valuations may eventually lead to permanent loss of capital. We believe that businesses with real quality are far and few. Even when we find one, would we buy it at any price? And how do we evaluate the estimated value for the company? Stay tuned for our next Market Intelligence, the last part of this series.
1) Horace Secrist, e Triumph of Mediocrity in Business (Evanston, IL: Bureau of Business Research, Northwestern University, 1933); Dennis C. Mueller, Pro ts in the Long Run (Cambridge: Cambridge University Press, 1986); Pankaj Ghemawat, Commitment: e Dynamic of Strategy (New York: Free Press, 1991); Bartley J. Madden, CFROI Valuation (Oxford, UK: Butterworth-Heinemann, 1999); Krishna G. Palepu, Paul M. Healy, and Victor L. Bernard, Business Analysis & Valuation (Cincinnati, OH: South-Western College Publishing, 2000); Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, 4th ed.
2) Death, Taxes, and Reversion to the Mean, December 14, 2007, Michael J. Mauboussin.