Why I Prefer Quality Over Quantity (Part 2: Defining & Defending Quality)
There are several ways to look at it.
The short version is that a high-quality company is one that takes care of your investment. When a recession comes, or the stock market crashes, there is comfort in the fact that high-quality businesses will end up better off on the other side. This works on many different levels.
It starts with the type of products that the business is selling:
The most robust markets involve products that people will still use even when their income drops. Some basic examples would be healthcare, or energy, or food. People may not buy as much when their money is tight, but they will still buy.
There are products that consumers can “trade down” to during a recession, such as discount brands.
Luxury brands may suffer when consumers trade down to the discount brands, but they can recover quickly when economic growth returns. There are also cases where people will continue to choose the premium product, when the benefits are significantly more valuable than the cost of a higher price.
An emphasis on quality also considers the financial health and financial returns of the business. Fast growth is exciting, but it is not always ideal. When growth is fueled by too much debt, or when it comes without profits, it can threaten the foundation of the entire company. Mistakes, and normal periods of bad performance, are amplified by borrowed money. Opportunities have no meaning when the business can’t pay its bills.
I prefer a more measured approach, inspired by one of the lessons from Romeo and Juliet. As Friar Lawrence warns the young Romeo: “Wisely and slow. They stumble that run fast.” The young Romeos of the investment world are often seduced by the fastest-growing companies (or, more often, the fastest-rising stock prices). But, like Romeo, their love is shallow, and it only lasts for a short time; at least until something newer and more exciting catches their attention. I want something more durable. Growth is good, but financial health comes before fast growth.
Stability is necessary, but so is flexibility. Markets and economic conditions can change quickly. A business needs stability to survive the initial shock of these changes, but flexibility is the way to recognize how to benefit from a changing market. This requires a broader perspective on how a company competes within its industry:
The most attractive business is one that operates as a monopoly but does not get regulated as a monopoly. The easiest way to understand this is to think of local monopolies, where one town is not large enough to have two competing businesses. Or a “toll bridge” where the bridge is the only way to get to the other side.
The next most attractive business is one that operates inside an industry that is difficult for new companies to enter. Economists call this “high barriers to entry.” These barriers to entry are generally regulatory (things like patents) or simply businesses that require huge investments, such as railroads. This type of industry, where massive amounts of money is needed just to survive, usually has about 3-5 major companies.
In industries where competition is fierce, or industries that do not have many opportunities to be different, there are still ways to build a durable competitive advantage. This can be made by something as simple as consistently keeping the lowest costs or the best new product development. It is more difficult, but some companies are good at it.
Whatever the industry, my goal is to identify a company that has proven its ability to compete. Preferably, I would also like to see a company that has proven its ability to innovate and reinvest in itself — with many more opportunities for reinvestment.
Beyond that, there is one more aspect to quality that does not show up in any financial screens: the management team’s ability to recognize the company’s position in the market and take advantage of reinvestment opportunities. If the management team itself is not capable of making the same evaluation as an intelligent outside investor (or if the management team has an incentive to ignore the concerns of the company’s owners), then the quality of the overall business is threatened. There are three basic tiers:
At the very least, I like to have a management team that thinks like owners.
Or, even better, a management team that has personally invested heavily into the company.
Or the best, and most rare, a management team that still includes one of the company founders. They will often have special insights on the industry and a unique incentive to preserve and grow the business.
It’s a pretty simple analysis. But there is some caution about focusing on high-quality companies.
Price is an important factor. Quality alone is not enough to make a great investment. An investment must also be made at a reasonable price that is consistent with the expectations of the company’s performance. Even the best businesses can be priced for perfection — and perfection is impossible.
The quality strategy is also an extra-long-term strategy. It’s not exciting, and it does not guarantee the best investment results every year; it can only increase the chances of having acceptable long-term returns. Short-term returns can be very good for different strategies at different times. Sometimes the more exciting strategies will outperform for a painfully long time, and investors in high-quality companies might begin to question the purpose of their patience. It’s a psychological challenge that comes with every investment strategy.
What makes the strategy work is a commitment to following the principles of identifying a high-quality business. When those high-quality businesses are recognized, it takes conviction and patience to wait for the right price, and even more conviction and patience to wait for business results that prove an assessment of quality. It’s not about predicting the week ahead or forecasting the next few months. It’s not about hoping that other investors will be willing to pay more. It’s about finding reasonable business stories that can meet long-term economic expectations, and not paying too much for the potential.
Nobody can be right all the time, or even most of the time. The best case is to make the biggest bets when the probabilities are most in our favor. An emphasis on high-quality companies with a long-term view can only serve to increase those probabilities.
This is the benefit of doing the research. Instead of owning everything and getting worried when it moves the wrong way, or making short-term trades based on short-term bets, investors in high-quality companies can find comfort and confidence in the quality of the businesses that they own. It’s a psychological benefit that is just as valuable as the math behind long-term growth.
That’s why I prefer quality over quantity.