We are adherents of the Munger school that argues it is better to buy an outstanding business at a sensible price, than a mediocre business at a bargain price. Then all you have to do is wait patiently while high returns on capital compound shareholder value over time.
It remains a work in progress, but our portfolio increasingly comprises a handful of such businesses.
This policy shares a number of similarities with an investment approach known as quality investing, which has seen significant popularity of late. That got us thinking: how does our approach to investing in outstanding businesses at sensible prices differ from quality investing?
Many practitioners of investment quality are very insightful and do tend to seek out businesses with similar characteristics to the ones we look for. When they describe quality, we usually listen. There are some, however, that when asked to define the concept of quality, recite a list of financial metrics such as revenue growth, wide profit margins, returns on capital and high free cash flow margins. True, these metrics are the important ones, but they represent just the outward manifestation of quality, not the quality itself.
Others can go one layer down and mention at least some of the following sources of competitive advantage: powerful brands, economies of scale, network effects, access to scarce resources or natural monopolies. These concepts are on the right track, but they are not the whole story either.
When pushed even harder to really define quality in detail, many end up sounding like Phaedrus in Zen and the Art of Motorcycle Maintenance:
when you try to say what the quality is, apart from the things that have it, it all goes poof! There's nothing to talk about. But if you can't say what Quality is, how do you know what it is, or how do you know that it even exists? If no one knows what it is, then for all practical purposes it doesn't exist at all. But for all practical purposes it really does exist. What else are the grades based on? Why else would people pay fortunes for some things and throw others in the trash pile? Obviously some things are better than others ... but what's the betterness? ... So round and round you go, spinning mental wheels and nowhere finding anyplace to get traction. What the hell is Quality?
Metaphysically Quality might be hard to pin down, but in the investment world we believe it can be found in the minor, but absolutely critical details of a product or a service that give rise to deep customer satisfaction and repeat purchase behavior even in trying economic circumstances, leading to the persistence, durability and defensiveness of the business. And it these characteristics that allow a company to price its product or service for the value it brings, not for what it costs to produce, creating wide margins and high returns on capital.
If we try to distill it further, however, we always seem to return to a definition that says that a quality franchise arises from a product or service that is 1) needed or highly desired, 2) is thought by customers to have no close substitute, and 3) is not subject to price regulation. Those conditions allow a company to regularly increase prices and earn high rates of return on capital.
We tend to add a fourth criterion of quality and that is management’s ability to allocate capital. If the addressable market of the current line of business is large and able to absorb the reinvestment of substantial amounts of capital, then there is a straightforward path to compounding shareholder value. If not, then management’s ability to intelligently allocate excess capital is key to assessing quality and the ability of the company to sustain returns.
There are broadly three options for the allocation of capital that cannot be intelligently reinvested in the current business: 1) investing in a new line of business, 2) pursuing acquisitions or 3) conducting share repurchases. The choice involves consideration of a host of factors, but the most critical is the relative price or cost of each alternative. In other words, the quality of management itself depends on its ability to estimate a sensible or fair price to pay for a business, including the ability to calculate a fair price for one's own stock. What makes sense at one price, is foolish at another.
And that leads us to the second question of what defines a “sensible” or “fair” price?
This is the more significant distinction between the Phronimos approach and the broader quality investment crowd. Most quality investors place only secondary importance on the price paid. Some even suggest that any stock trading at a price sufficient to attract the attention of Value investors must, by definition, not warrant consideration (fifteen years into the current bull market Value investing has become a pejorative term!). Inherent in this view is the belief that markets are always efficient in identifying quality, and that quality itself does not change through time. In a sense it is a form of the efficient market hypothesis.
The danger of placing only secondary emphasis on price is that it allows investors to pay any conceivable price for a business of a certain quality. As the thinking goes, for a truly outstanding business, does it matter if you pay 20 times rather than 15 times? What about 25 times? Even 40 times? Ultimately the business will grow into the valuation - so the thinking goes. Taken to its logical extreme, price in its own right is a proxy for quality (the view implied in the above criticism of Value investing). Ultimately the unmooring of price from any solid basis of intrinsic value can lead to major problems. Investors are at risk of committing a dual error. If the investor misappraises the underlying quality of the business, he or she is at risk of overpaying for a business that turns out to be of only average quality.
We believe that paying a sensible or fair price is of equal importance to investing in a great business. Ben Graham’s “margin of safety” still applies even to quality companies. Graham’s margin of safety principle asserts that investors need to leave room for error, imprecision, bad luck or the vicissitudes of the economy and stock market. His Value philosophy insists that investors should first strive to avoid loss, and the best protection against loss is to avoid overpaying.