What price quality?

Beauty may be in the eye of the beholder but quality is in the eye of the buyer. There is no unique definition of what makes a company high quality.  Some investors will look for high returns on capital, others strong and sustainable competitive advantage.  Alternative measures include the rate of growth and low variability of profits. My colleagues Jeremy Thomas and Matt Hall have opined on the subject in past posts here and here.

However, if you look for companies in different industries that display a number of these attributes, then these “quality” companies have typically performed well over recent years. For example, Reckitt Benckiser, Bunzl, Relx (Reed Elsevier) and British American Tobacco have seen their share prices rise by between 54% and 167% over the 5 years to the end of May.

It is easy to understand why this should be the case. Economic growth is modest, and industries ranging from oil and mining to food retail and banking are struggling from difficult trading or regulatory conditions.  Businesses that can grow reliably in this environment are naturally in demand.  Furthermore, with interest rates near zero, or even below zero in many parts of the world, investors are drawn to companies paying a secure dividend stream with an asset base that should grow in real terms.

However, it is interesting to look at where these strong share price returns have come from. In Matthew Tillett’s blog – Beware the bond proxies – he compares and contrasts Unilever’s share performance to that of an industrial distribution company – Brammer.

The table below does a similar analysis for the four companies above. From 2010 to 2015 they grew their earnings by an average of 34%, a very creditable performance in the economic environment.  However, the shares are up by 113% on average, excluding dividends.  So, around two thirds of this return has come from a re-valuation of their profits.

quality

In 2011, investors had to pay between 12.6x and 15.5x earnings to buy all these businesses. Today that multiple is between 18x and 27x.

Investors may, understandably, be happy to pay these prices to invest in high quality companies. Indeed this type of investment strategy has become increasingly popular in recent years.  However there are a number of risks with this approach.

The first risk may concern professional investors more than private investors. It is the risk that life may get better.  If the economy starts to improve and economic growth picks up, it will no longer be so difficult to find growing companies – a rising tide lifts all boats.  In this case, the scarcity premium of genuine quality growth stocks may decline and these companies’ shares could underperform the broader stock market.  Investors may not lose money in this scenario but they could perhaps make better returns elsewhere.

The second risk is valuation risk. The higher the price of a share today, the greater the risk has to be that it will be trading at a lower valuation in the future, when an investor may want to sell it.  Another way of thinking about this, is that for this group of companies to deliver the same return in the next five years as the last five, assuming they exhibit the same growth trajectory, they would need to be re-rated to an average of 35x earnings by 2021.  Not impossible, but I would suggest highly unlikely.

The third risk is perhaps the greatest. Some of these businesses may disappoint operationally.  Today’s apparent quality may not last.  If you had produced a similar list of quality companies five years ago, it could easily have included Tesco, Rolls Royce and Standard Chartered.  These businesses have all had a quality tag at certain points, but have been terrible performers in the recent past.

Although “quality” companies may look strong today, it is impossible to be sure they will not hit speed bumps, or worse, in the years ahead. The higher the starting valuation, the smaller the margin of safety for investors and the bigger the impact if a company disappoints.

Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”.  Today many investors know for sure which shares are quality companies.  If they are wrong, they will get into trouble.  But, even if they are right, a quality company does not necessarily make a quality investment – it has to depend upon the price paid1.

Simon Gergel

 

1. This is no recommendation to buy or sell any particular security

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Author - Simon Gergel

Simon Gergel

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