Quality is an essential ingredient in many aspects of life, including investment. In its simplest form, quality represents the ability of an asset to endure, adapt and thrive across many different environments. One-of-a-kind assets, talented management, strong balance sheets, consistent free cash flow, high barriers to entry and large reinvestment opportunities are all signs of a high-quality business. If you find a business like this, you are already standing on first base. But is quality alone enough to ensure a great outcome and win the long-term investment game? The short answer is, not entirely. Valuation matters and ideally, you find both in an investment.
Two well-regarded investors have held similar views on the topic of quality and value, and, for both, quality carries a higher weight though neither liked to overpay for an asset. Warren Buffett is famous for saying, “it is far better to buy a great company at a fair price, than a fair company at a great price.” Bob Torray, who I worked for in my first asset management job, used to say, “the longer you intend to hold a stock, the less relevant price paid is and the more relevant the quality of the underlying business becomes.” For both esteemed investors, this is in large part because reinvestment opportunities play such an important part in long-term shareholder value creation and quality companies tend to find smarter or better ways to reinvest back into the business than lower quality ones.
My own version of this quality versus value theme takes me back to my twenties when I was visiting a friend in Chicago. It was wintertime and, in a hurry to make the flight, I neglected to pack a coat. With some time to kill, I went to a Nordstrom on the Magnificent Mile. Overwhelmed by the plethora of options I zeroed in on a beautiful wool coat with a great liner that felt like silk. I could hear my father saying, “don’t try on the coat unless you plan to buy it,” but with the assistance of the salesperson, I tried it on anyway. The fit was perfect, but it was more than I had ever contemplated spending on a piece of clothing. But I was in the big city and bought it! For the next fifteen winters, that coat took great care of me and provided a far higher return on investment than I ever imagined at the time of purchase. Quality has a way of doing that, but are there limits?
Which brings us to today’s market environment. The narrow breadth of the market in 2023 is well documented. A handful of large stocks have driven returns. Nobody debates the quality of these technology-oriented businesses. They are innovative, well run and the world continues to digitize itself. But if you pay 100x earnings for a business, there is an assumption of growth built into that valuation. Priced at these levels, nothing can go wrong because the margin of safety in the price paid does not allow for it. Late arrivers who bought the stock with the expectation of growth as far as the eye can see will be disappointed and sell if it doesn’t materialize because absent growth, the payback on the investment is 100 years!
In another remarkable measure of how far quality can take a business, a well-known tech company, currently carries a $3.0 trillion market cap which is bigger than the entire Russell 2000 universe of companies combined. Nobody would dispute its place in the Mount Rushmore of Corporate America, but from the standpoint of the law of large numbers, is it more likely that a $3 trillion market cap company doubles over the next six years (generating a 12% annualized return) or that a $300 million upstart does? There is little doubt the $3.0 trillion company’s business will be more resilient to economic disruptions and change than a $300 million company, but is it easier to find a $3.0 trillion market cap creating business opportunity or a $300 million opportunity for the second company and its shareholders?
The beauty of investing is that everybody has a different goal for the holdings in their portfolio. Some want and need the battleship; others need or want the smaller speedboat. Many investors seek both to receive the benefits of both. That is what makes markets and is one of the key principles of diversification. Regardless of the securities you seek for your portfolio, however, if you start with a quality first bias and then layer in discipline on valuation, you give yourself two ways to win. But in the end, quality, like a good winter coat, is a smart starting point for weathering the harshest of market conditions.