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What is Quality Worth

What is Quality Worth

| March 17, 2022
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Occasionally, I come across a transformational way of looking at investing. I am a big proponent of the “Quality” factor – looking primarily at companies with low levels of debt, positive and growing operational cash flows and earnings, and capital light asset models that tend to lead to consistent high returns on invested capital. Unfortunately, these businesses are rarely on sale and tend to command a premium valuation relative to the market, theoretically limiting an investor’s expected return over time and margin of safety. This is a fair assumption, but to what extent does it pan out?

SPOILER ALERT: The results are highly counterintuitive.

I recently read Investing for Growth by Terry Smith of Fundsmith LLP, the UK’s largest open-ended equity fund. I was utterly shocked by a graphic he used. A picture is worth a thousand words, and this chart1 speaks volumes.

Based on 12-month trailing P/E’s calculated from January 1, 1973, through September 30, 2019. The price return of the MSCI World Index over the same period was 6.2%. 

TWO FAMILIAR EXAMPLES

Over a 50-year horizon, to simply earn a 7% return per annum, you could get away with paying a 63 P/E ratio for Coca-Cola Co. or a seemingly insane 129 for Hershey – consumer staples stocks that have been household names since the 1800s. It seems ludicrous but, in fact, the numbers play out that way. These companies with respectable year-over-year return profiles are well known consumer brands that deliver consistency in their products and their profits.

Look at the total returns for these two companies since January 1973.

Hershey Co (HSY): 13.27% Compound Annual Growth Rate2
A single $10,000 investment becomes $4,518,500 with reinvested dividends:

Coca-Cola Co. (KO): 9.62% Compound Annual Growth Rate3
A single $10,000 investment becomes $1,414,000 with reinvested dividends:

These charts demonstrate the effects of long-term compounded growth where over half of the final value was generated in the past 10 years. They also demonstrate periods where returns can stagnate and even experience hefty downsides; the key in these periods is to determine whether the viability of the business warrants a continued investment. I believe that falling back to the robust fundamentals and operating consistency of high-quality companies combats the inherent desire in turbulent times to instinctively sell. However, if a business changes to a degree that its competitive advantages fade or its management acts imprudently, selling shares may be warranted. It’s important to keep a vigilant eye on financials and company news.

Both examples are from the consumer staples market segment to illustrate that even sectors that are more defensive can generate attractive long-term returns. Of course, other sectors and industries have similar characteristics and should be explored as well.

BROADER MARKET COMPARISONS

Individual absolute returns are great, but what about relative returns to the broader S&P 500? The S&P 500 performance since January 1973 is shown in the next chart.4

S&P 500: 10.88% Compound Annual Growth Rate
A single $10,000 investment becomes $1,581,000 with reinvested dividends:

To compare, a single $10,000 investment in the S&P 500 would have translated into roughly $1.58 million today. This is admittedly higher than the Coca-Cola example, although volatility was lower for Coca-Cola, which led to a much better risk-adjusted return for Coca-Cola over that time frame.

Obviously, there is more than one way to invest money successfully, and many different strategies have proven to be quite profitable. What resonates the most with me is having the reasonable expectation that returns over the long-term will gravitate towards the performance of the underlying business.

Investing in quality businesses that generate high returns on capital and have strong balance sheets and operating profits makes it easier to predict those returns, stay invested during market downturns, and to filter out wide swaths of the market, saving time and energy while maintaining peace of mind.

Dean Schwefel, CFA®
Senior Investment Analyst

SOURCES:
1. Investing for Growth by Terry Smith, Fundsmith LLP. Based on 12-month trailing P/E’s calculated from January 1, 1973, through September 30, 2019. The price return of the MSCI World Index over the same period was 6.2%. Data sourced from Ash Park and Refinitiv Datastream, excludes dividends.
2. YCharts. Hershey's annualized total return from January 1, 1973, to Febraury 3, 2022.
3. YCharts. Coca-Cola Co.'s annualized total return from January 1, 1973, to Febraury 3, 2022.
4. Macrotrends.net - S&P annualized total return from January 1, 1973, to Febraury 3, 2022.

Disclaimer: Investing involves risks, and investment decisions should be based on your own goals, time horizon, and tolerance for risk. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. The forecasts or forward-looking statements are based on assumptions, may not materialize, and are subject to revision without notice. The market indexes discussed are unmanaged, and generally, considered representative of their respective markets. Index performance is not indicative of the past performance of a particular investment. Indexes do not incur management fees, costs, and expenses. Individuals cannot directly invest in unmanaged indexes. The author, or the advisor with whom the author is affiliated, has an interest in the securities mentioned in the above article/blog post. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.

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