Part 1 - Fallacy of Owning Quality Companies At Any Price
by Saket Mundra, CFA, MBA
Global stock markets have witnessed a tremendous rise after the meltdown during the 2008 economic crisis. In our view, one of the primary themes of the current bull market has been investors’ dogged pursuit of owning “quality” companies for their investment portfolios. Scathed from losses in 2008- 09, investors found solace in owning stocks of companies with stable earnings and yield. History has shown that every bull market in the past had its own ever-lasting theme that most investors gladly embraced – whether it was owning “Nifty 50” stocks in the 1970s or buying technology stocks during 1999. Periods of unquestioned conviction in a theme have invariably resulted in a bust and consequently a permanent loss of capital. Given this backdrop, we feel that it is time to be circumspect because of the valuations that the stock prices of these quality companies currently reflect. In this series of articles, we question the merit of current investment practices which suggest owning quality companies at any price.
The most vocal proponent of buying quality companies at fair prices has been none other than the Oracle of Omaha, Warren Buffett. According to him, a quality company is the one that earns higher returns than its cost of capital due to the presence of competitive advantages that endure for a long period of time. This strategy became even more popular after the 2008 crisis as investors started to chase businesses with stability and certainty of earnings. As the current bull market unfolded, we believe that more and more investors piled on, bidding up prices of quality companies to unreasonable valuations. Moreover, whenever valuations of these companies have been questioned, most investors have simply dismissed the analysis by using Mr. Buffet’s long run track record as justification for themselves and others. With humility, allow us to dampen the enthusiasm – most of us are not Mr. Buffett.
We would first mention that Mr. Buffett’s suggestion of buying quality companies makes complete sense as long as we abide by how he defines a quality company, fair price, and a long time horizon. In our opinion, most investors lack the abilities of Mr. Buffett, and just as importantly, they operate their investing practices in a much different fashion. There are glaring faults in the way the market attempts to interpret and apply his recipe for outperformance. In this article we discuss the first ingredient – a long time horizon - with follow-up pieces to focus on defining a quality company and fair price.
The first peril lies in the assumption that investors share Mr. Buffett’s time horizon and have a similar appetite for market gyrations through time. The available evidence suggests the opposite – the average Stock Duration1 for institutional investors has ranged within 1.2 -1.6 years during 1985 - 20102 . On the other hand, Mr. Buffett has held a stable allocation to his largest holdings for over 10-20 years, which renders his portfolio’s stock duration to be more than double the industry average3 . For example, since he started accumulating shares of Coca-Cola in 1988, Mr. Buffett has never sold a single share in the company4.
By having a much longer time horizon than the rest of the market, he is able to exploit the timehorizon arbitrage. The game is simple, he owns a set of companies that compound capital at higher rates for a much longer period of time than currently priced in by the market. The concept was introduced as “Competitive Advantage Period” (CAP) by Michael Mauboussin and Paul Johnson in 19975. In a simplistic way, one can think of “CAP” as the period for which a company will earn returns above the cost of capital. The opportunity exists as long as the market underestimates CAP when determining the value of a company, which it has usually done. However, to be able to benefit from the opportunity, the market must correct for this error of underestimating the CAP which requires a longer time horizon than the averages stated above.
The notion flies in the face of the economic theory which suggests that competitive forces or other factors eventually bring returns of all companies in an industry to the cost of capital. What Mr. Buffett and the CAP paper proposes is that this theory does not hold for a very small percentage of high quality companies, as their CAP actually endures through time. As an example, consider the case of an investor who buys Coca-Cola, a high quality company, in 2016. While determining the value of the company, the investor assumes a CAP of 10 years – implying that the company will not earn any excess return after 2026. One year later in 2017, the investor realizes that Coca-Cola’s CAP remains intact and rolls forward for the next 10 years. This implies Coca-Cola would earn excess returns through 2027 instead of 2026 as originally estimated, and that this additional year of excess returns was not built into the value of the company. As a result, the investor and the market as a whole would bid up their price of the stock to reflect this bonus return and long term stockholders earn incremental investment returns.
As you can imagine, this idea can prove quite impactful over time from a return perspective. However, there is one important caveat: investors should be careful that the bonus return accrued over their time horizon is not already priced into the stock. In other words, they have a time horizon greater than what’s implied in the market price. We find it perplexing that investors have a time horizon longer than what’s implied in the prices of most of the “quality” companies today given the average stock duration mentioned earlier. On the other hand, investors such as Mr. Buffett can capture this bonus for many years as they have extremely long holding periods, without worrying about what’s implied in the current price.
In today’s market, we find that these companies are held near and dear by the market and trade at valuations that suggest unreasonably longer payback periods. For example, when we see companies trading at Enterprise Value/Sales (LTM) multiples in the high-single or low-double digits or Enterprise Value/EBIT (LTM) multiples in the mid-twenties, we become extremely cautious. In essence, what the market is saying while paying a 25 times EBIT multiple is that one would earn their investment back in a minimum of 25 years, provided that the company maintained its current earnings and returns. The payback period might be slightly lower for companies that are growing and reinvesting – nevertheless, we believe that the investors in such companies are likely to be disappointed with the investment returns they generate as compared to their expectations.
To summarize our view, it would be fair to say that the quality premium and the time horizon arbitrage exist and are an important source of investment returns. However, it is our sense that due to excessive investor focus on quality companies, this source of excess return appears largely eroded.
At junctures like these, we fall back upon two vital tenets of our investment philosophy and process – “Seeking the Truth” and a focus on “Valuation”. By constantly seeking the truth, we avoid falling prey to the illusions that our time horizon is as long as Mr. Buffett’s and/or we can predict the future of companies and industries for such extended periods of time. Who wouldn’t want to own a company that has certainty of high returns on capital, recurring free cash flow, and is able to grow every year? When we encounter such a company, we strive to take a prudent approach that considers the price one is willing to pay for perceived “quality”. We believe that our process guides us in making sound investment decisions for our clients and stay true to who we are.
In the second part of our series, we discuss the characteristics of “quality” companies, how the market defines it, and what kind of quality companies truly lend themselves to the Buffett’s model of investing.
Stay tuned for our next Market Intelligence.