“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.”
This quote, from Ben Graham’s The Intelligent Investor, is a pretty even-handed warning. He cautions investors about paying too much for high-quality stocks, BUT he also implies that within reason this is a venial as opposed to a mortal sin. The mortal sin would appear to be an insufficient attention paid to quality by investors. That is specifically called the “chief hazard” confronting the average buyer of securities. Clearly, Ben Graham viewed quality as a vital risk control in the portfolio.
What did Ben Graham mean by quality as he used it in the above quotation? Fortunately, he makes that pretty clear in The Intelligent Investor. He believed that the chief characteristic of a quality security is sustainable earnings power, defined as, “the amount that a firm might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged.”
So, the focus of interest for the prudent investor should be the threats to sustainable earnings power. Any experienced investor should be able to enumerate the three categories of threats:
- Cyclicality, characterized by commodity products and capital-intensive production
- A business in secular decline, with maturing product life cycles and disruptive competitors
- Capital allocation errors that threaten the intrinsic value of the investment through various kinds of dilution
As an investor, you can take two approaches to these earnings power threats. If you have a really good nose for numbers and conservative accounting policies, you can try to turn them to your advantage by buying a diversified portfolio of such companies when the shares are extremely cheap statistically. This is the canonical value investment style. Some of your positions will be permanently impaired and lead to irreversible capital losses. Many positions will struggle along as the walking wounded of the stock market. But some will turn around spectacularly and deliver amazing upside. And the portfolio as a whole will deliver good returns over time, if you price all those different risks approximately correctly.
There is another way to deal with these threats to earnings power besides trying to price them. I think this is where Warren Buffett had one of those epiphanies that happen to really smart people. He asked the question, “what if you just tried to avoid them?”
Let’s look at those threats to earnings power that we identified. Which ones would be easiest to avoid?
Cyclicality is an obvious one. Companies that have commodity products and huge amounts of committed capital can simply be avoided. It is also easy to avoid companies with short or maturing product life cycles, as displayed by shrinking revenues and profits.
So, you are going to look for capital-light businesses with long product life cycles and resilient top lines. These companies are often characterized by high margins, high returns on capital and strong free-cash-flow generation. In a word, quality. Such companies are typically found in fast-moving consumer goods, household products, healthcare goods and services, and light industrials.
In order to monitor the earnings power of those companies, you are going to have to get obsessive about the remaining threats, the risks you can’t easily avoid: product maturity, disruptive competitors and capital allocation mistakes. Your valuation work will be focused around those three things.
Product maturity is one threat of the quality buyer. Even very long life cycle products may not be long-term winners if demographics and consumer tastes change. And they are changing all the time.
Disruptive new competitors are a major threat. The Internet, all by itself, undermined many of the high-quality businesses that would have been cornerstones of a quality-value approach in the 1980s and ‘90s. Just think of any media business, like broadcast television, or especially daily newspapers. Warren Buffett’s lieutenant Charlie Munger has been saying for years that the moats around good businesses get harder and harder to defend every year.
As if that wasn’t enough to deal with, quality buyers also have to deal with the enemy within: management. Capital allocation mistakes are a particular risk if you have a lot of capital to allocate. The biggest source of errors by far is mergers and acquisitions. Historical data shows pretty conclusively that these situations usually dilute acquiring shareholders, either because the target has inferior economics (the process Peter Lynch refers to as diworsification) or because management pays too much for it. On the other hand, a really excellent management can add a lot of value by intelligent capital allocation.
This is just a glimpse into the considerations for a quality-value investor, and one of the reasons why the idea of buying and holding high-quality companies purchased at attractive prices is a lot harder than it sounds. It requires a great deal of work on understanding the business, assessing management and keeping a permanent eye on the downside.
Graham, Benjamin. The Intelligent Investor. HarperCollins Publishers Ltd. New York, 1973.