Quality Versus Value: A False Dischotomy
“Is it a great business? That’s the key question. Is it earning high returns on capital and commanding high margins? Does it have a good history of growing its intrinsic value and rewarding shareholders? Warren Buffett has this great phrase: “If a company has a lousy past and a great future, we’ll miss it.” It’s the same thing here.”
“By owning great companies, you can just forget about all the noise and the irrational market fluctuations. And slowly get rich.”
• Francois Rochon, founder, Giverny Capital (GuruFocus interview)
. . . . . .
“Great businesses are rare and so are the opportunities to purchase them advantageously. We attempt to deserve what we want by keeping this firmly front-of-mind.”
• Chuck Akre
. . . . . .
“Why would anyone want to own a mediocre company just because it’s cheap, when you can own and live with great companies?”
• T Rowe Price
. . . . . .
“People don’t believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it”
• Jeffrey Ubben
. . . . . .
“I looked back at the investments that had worked best for me over time and they were regularly in companies with superior business models. I concluded that the ultimate margin of safety was in the quality of the business and not the cheapness of the stock, so I re-orientated my process and decision-making around that”
• Jake Rosser
. . . . . .
“Other investors persistently underestimate quality, resulting in unduly low market valuations for the very best companies. This is the core proposition of Lindsell Train’s investment approach and one that provides us with an enduring market inefficiency to exploit.
To me it appears that exceptional companies with durable competitive advantages are in fact cheap almost all the time. The point is such companies are rare. It is plain wrong to expect them to be valued similarly to what is the vast majority of ephemeral, low value-added businesses.”
• Nick Train
. . . . . .
“Ben Graham had blind spots. He had too low an appreciation of the fact that some businesses were worth paying big premiums for.”
“We’ve really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. 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.
“So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.”
“Once we ‘d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.”
“A great company keeps working when you’re not. A great company will eventually earn more and more and more while your just sitting and doing nothing. And a mediocre company won’t do that. So you’re harnessing a long range force that will help you. It’s very important. These mediocre companies, they by and large are going to cause a lot of agony and very modest profits. If you do fine, you’ve got to sell it and find another one. It’s a lot of work. Whereas you just buy one great company, and if you get the right thing at the right price, you just sit there.”
• Charlie Munger
Fastenal (FAST). FAST sells nuts and bolts, sounds basic enough… but the returns are far from basic. The company averages around 20% returns on capital and produces very consistent results. 25 years ago, the stock traded for a split adjusted $0.32. Today, it trades at $44, or 138x the price in 1989. The stock has averaged 21.8% annualized returns not including dividends. This long term result nearly matches the company’s average return on capital over time.
Fastenal earned roughly $3 million in 1988, and a buyer of FAST paid somewhere around 25 times earnings for FAST in 1989. But a buyer could have paid 50 times earnings for FAST in 1989 (or roughly $0.65 per share) and the compounded annual return would have only decreased from 21.8% to 18.4%…. a big difference over time, but certainly still a splendid result.
Again, I cannot emphasize enough that valuation is more important over shorter time periods, quality is more important over long time periods (10-15 years or longer). The longer you hold a stock, the more important the quality of that company is, as your long term returns will approximate the company’s internal returns on capital over time.
• John Huber, Saber Capital Management
“Inferior quality generally produces inferior economics”
“I would say that if it’s a really wonderful business, we probably come up with higher intrinsic values than most people do.”
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
“Time is the friend of the wonderful business, the enemy of the mediocre.”
“Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10% too high or 5% too high or something of the sort.”
“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”
Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. I don’t think it is going to be hurt by the Internet. That’s the kind of business I like.
“Generally speaking, it pays to stay away from declining businesses. They are very difficult to value. We have several declining businesses – the newspaper business is a declining business. We will pay a price to be in that business but that is not where we are going to make a lot of money. All the money at Berkshire is going to be made from investing in growing businesses. I would never spend a lot of time trying to value a declining business that I call a cigar butt (one last free puff out of the business). I can spend the same amount of energy and intelligence analysing a growing business and am going to get a better outcome. At Berkshire, we have some declining businesses. We started with declining businesses, textiles, US made shoes, Blue Chip Stamps – We have one business that did $120 million in sales in 1968 and last year did about $20,000 in sales. We’d like to bring the sales chart out and put it upside down.”
• Warren Buffett
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards — so when you see one that qualifies, you should buy a meaningful amount of stock…
“…Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
• Warren Buffett, 1996 Shareholder Letter
“The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn’t earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money but can’t generate high returns on incremental capital – for example, See’s and Buffalo News. We look for them [areas to wisely reinvest capital], but they don’t exist.”
• Buffett at the 2003 Berkshire Hathaway meeting
“It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for “bargains” – and had the misfortune to find some. My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England textile manufacturers.”
• Warren Buffett 1987
“My investment mistakes are too numerous to list here. I noticed a few years ago that two common threads ran through all my investing mistakes. The first was that I was buying inferior businesses due to what I perceived at the time to be a low multiple (but alas not a low valuation). The second was that I was buying inferior businesses due to the prospect of a fast buck or what analysts term a catalyst”
• Robert Vinal
Estimating value in exceptional companies is interesting, but selecting the most apparently undervalued of the group runs the risk of concentrating positions on the weakest and/or most volatile companies in the exceptional group. How much more are the most consistently profitable companies with the strongest balance sheets and fastest growth rate worth versus the average public company?
“The risk of paying too high a price for good-quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”
• Benjamin Graham
Ben Graham made more money in one growth stock, GEICO, than in all of the rest of his investing career which encompassed thousands of trades in value stocks over decades, as he discusses in his book, The Intelligent Investor. In the time he owned it, it went from $7 per share to $54,000.
“We know very well two partners who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way, they did quite well through many years of ups and downs in the general market; they averaged about 20 percent per annum on the several millions of capital that had accepted for management, and their clients were well pleased with the results.
“In the year in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half interest in a growing enterprise. For some reason, the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.
“In fact it did so well that the price of its shares advanced to 200 times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates.
“Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.
“Veracity requires the admission that the deal almost fell through because the partners wanted assurance that the purchase price would be 100 percent covered by asset value. A future $300 million profit or more in market gain turned on, say, $50,000 of accounting items. By dumb luck they got what they insisted on.”
This is an absolutely crucial issue when investing in exceptional companies. Quality is worth a premium. The fundamental question is how much of a premium, and what impact, in good and bad markets, does that investment principle have on risk incurred and ultimately on long term results.
Our conclusion: price-to-intrinsic value is relevant in exceptional companies but should not be over-emphasized. The returns in these stocks is made on the value created over time as opposed to the bargain value at the time of the initial purchase. To the extent value is considered, two factors are important:
- Price in relation to free cash flow, book value and dividend yield (if any) versus the historic long term price to value relationship indicated by these same yardsticks. In other words, a company that has historically traded at 200 percent of the market’s price to intrinsic value can be considered reasonably priced at a 100 percent premium, even if the overall market is trading at no premium.
- An investor’s assessment, based on trends in margins, capital turnover, leverage and liquidity, as to whether or not historically-superior growth and profitability are likely to continue.
The final word goes to Marc Andreesen
“Good is the enemy of great. We see many companies that are just fine … founders are good, market seems good, product seems good, customers kinda like it, and they got a little revenue and it’s all fine, but those companies tend to never go anywhere. Every once in a while we’ll see these companies that have some extremely strong strength, some extremely special wonderful thing going on, that by the way may have all kinds of problems and issues, but there’s something at the core of what it is that’s really special and magical. And those are the ones that we want to do. We’re trying to stock our portfolio with just investments like that.”