Investors should not sacrifice quality for cheapness

In many ways, this debate is the wrong one. Anyone who has been around the world of investing for any meaningful amount of time will have been told or have read that the way to generate market-beating returns is to buy cheap because valuations eventually mean-revert. This means that cheap shares are supposed to improve in price and expensive ones get cheaper. But cheapness is no guarantee of investing success, and arguably never has been. You can’t ignore the performance of the business behind the cheap share.

Yet buying cheap has acquired legendary status as an investing strategy due to the writings of Benjamin Graham, in his famous books including Security Analysis and The Intelligent Investor. In days gone by when the stock markets were not as well informed and as well followed as they are today, it was much easier to unearth undervalued and unloved stocks that made investors money.

However, those of you that are reasonably well read on the subject of investing will know that Graham made most of his money in his investing career from one investment – the insurance company GEICO – which gave him more than all his so called cheap “cigar butts” put together. His most famous disciple, Warren Buffett, did well with the cigar butt approach between 1956 and 1969 and then gave up on it because it didn’t work any more.

This has not stopped legions of investors since then buying shares with low price/earnings (PE) ratios, high dividend yields, high free cash flow yields and low price to book values in the hope that their value goes up. Some buys work out, but the vast majority do not because the shares are cheap because they deserve to be.

This sounds harsh, but it is in no way meant to be a criticism of the businesses behind the cheap shares and the people who run them and work for them. It is a mere statement of fact that cheapness, more often than not, reflects the harsh reality facing a business. It may face fierce competition, cost pressures, financial stress and a lack of growth. This means that its profits and cash flows are unlikely to grow and stand a good chance of actually shrinking.

Buying cheap pays off when the problems facing a business are temporary and can be put right. Buying a cheap share in a business that will continue to struggle is not a route to investment riches.

More often than not, buying a share of a business with these characteristics is very much like buying a very cheap bottle of red wine in a supermarket and expecting it to taste like a vintage claret. Or buying an old banger from a second-hand car lot and expecting it to drive like a minted new one fresh off the showroom forecourt. Now and again you might get lucky, but usually you get what you pay for and this often ends in disappointment.

What the successful investors of the past decade have shown is that cheapness for cheapness’ sake has not worked. A combination of high-quality businesses and growth (not necessarily a lot of growth) has been the way to go.

High-quality businesses are scarce. They create products and services that help solve problems or make things better for their customers and they do it in a way that few of its competitors copy. This allows them to become very profitable as characterised by high profit margins, high returns on capital employed (ROCE) and high free cash flow margins.

They also have other desirable characteristics. Their revenues and profits tend to be very consistent and don’t move around a lot when the economy changes, and also have the capability to keep on growing. This dependability and consistency is understandably very attractive to investors who have been prepared to pay very high valuations to sleep well at night.

In this sense, business quality reduces an investor’s risk. It has led many quality companies to be referred to as bond proxies – in that the predictability of their cash flows is bond-like – and that they can be valued like bonds with the added benefit that their cash flows can grow. With low yields on government bonds, the argument is that bond proxy companies can trade on very high valuations, as seen in high multiples of profits or cash flows or low earnings or cash flow yields.

So why are so called value investors having such a bad time? The truth is that they are not. All investors are value investors, or at least they should be. They are all trying to buy shares in businesses for less than they are worth. What the buyers of cheap shares have perhaps got to face up to is that they have got it wrong. They have fallen into the same trap as the buyer of a bottle of cheap supermarket wine. The buyers of quality businesses, on the other hand, have seen growth in profits grow the value of these businesses and they have made money – lots of it.

But the value of many of these quality stalwarts is now so high that perhaps the odds are stacked against them. Could investors be paying so much for quality that the maths no longer stacks up? This is a subject that I have written about a lot over the past year or so, but I wanted to look at it from a very simple and powerful perspective.

By this, I mean that a rational buyer of these businesses outright at current valuations might find it very hard to get as much in future profits or cash flows as a buyer of a cheap, no-growth business, even if the quality business grows strongly for a long period of time. This boils down to what successful investing is all about: how much to pay for a stream of future profits or cash flows. The less you pay, the higher your future returns are likely to be.

I came to this conclusion last week when I was looking at two very different businesses. Ramsdens (RFX) makes money from selling travel money to holiday makers, pawnbroking, buying and selling jewellery, and buying and selling precious metals. Its profits aren’t growing much and are not expected to grow that strongly in the future.

Its valuation reflected this, with the shares trading on a trailing PE ratio of 10.4 times. Put another way, an owner receiving all the profits outright would receive £9.65 per £100 invested. At the other extreme, Halma (HLMA), a great example of a high-quality industrial equipment and products business, grew its profits last year at a rate of 10 per cent. Its shares were trading on 38 times trailing earnings. An outright owner would be receiving just £2.63 per £100 invested.

Which business do you want to own? Which one will make you the most money from the perspective of an outright owner?

Most investors would probably want to own Halma. I would certainly sleep more soundly at night given the stability of its profits. But would I make more money and would I be exposing myself to the risk of disappointment by paying too much to own it?

If Ramsdens earns £9.65 per £100 invested per year forever and Halma keeps growing its shareholder profits at 10 per cent a year, it will take it 23 years for the owners of Halma to make more cumulative profits than Ramsdens. I don’t know about you, but I don’t really like those odds despite Halma’s indisputable superior business quality. It’s a long time to wait.

Ramsdens vs Halma cumulative income per £100 invested at current valuations

Source: Investors Chronicle

Of course, you can rightly argue that we are not outright owners and that the stock market will continue to value Halma’s profits more highly. You could be right by saying that Ramsdens’ profits will wobble about more. But what if Halma’s profits don’t increase by 10 per cent a year but by much less? If they only grew by 5 per cent a year it would take 45 years to make more money than a no-growth Ramsdens.

In this scenario, the chances are that Halma’s share price would be hammered. My point is that the expectations baked into Halma’s share price have made its shares very risky. Probably much more risky than Ramsdens’.

Yet there seems to be an almost blind faith in these high-quality businesses and that valuation does not matter. The shares are a buy at any price.

I’m not arguing that high-quality businesses should not trade on high valuations, but there are limits. Good investors think like business owners and I’m not sure that business perspective investors are getting a good deal if they buy Halma at its current share price.

Stock market investors and quality fund managers will hope that the market’s love affair with it will persist even though the future profit growth implied by the share price looks very tough to achieve. In doing so, you might ask whether they have crossed the boundary between being an investor and becoming a speculator.

Very expensive quality and growth shares

Source: SharePad

The same can be said for many excellent businesses trading on the London Stock Exchange. If we look at some of the most successful UK-listed shares of recent times, look at the price you are having to pay for quality (measured by a one-year forecast rolling PE ratio). Many of these shares are momentum plays – but what happens when profit forecasts stop being upgraded? – while others are priced on the assumption that strong growth can continue for many years to come.

Even with the argument that interest rates are low and possibly going lower, these businesses still need to deliver meaningful rates of profit growth for many years to come.

Consider what might happen if the company’s business model becomes threatened or investors start to question the sustainability of it. Hargreaves Lansdown is a case in point, with its shares having fallen by more than a fifth during the past month as its relationship with fund managers and the fees it makes from funds has come under the spotlight.

Beware of quality impersonators

I fully understand why many will find the valuations of a lot of the shares above way too rich and too risky for their liking. This has led some investors to think that they can buy quality for very cheap valuations. This is rarely true.

Source: SharePad

The four companies listed above have good profit margins and ROCE, which are hallmarks of quality and come with shares on very cheap valuations. This is because their levels of profitability are temporary, or there are good grounds to think that they will be.

Barratt’s profits were decimated in the last recession, as were Somero’s. The latter has suffered due to bad weather, which was the cause of its recent profit warning. These problems can happen again and probably will, which makes them both quality and value traps.

Striking a happy medium between quality and price

I do not think that you should sacrifice quality for cheapness, but firmly retain the view that valuations matter – especially for those practicing long-term buy-and-hold investing who want to compound the value of their investments over a long period of time. Put another way, you should not sacrifice valuation for quality either.

As I wrote in this column a few weeks ago, many stocks in the UK market look cheap, but this is because they are of inferior quality. It’s sad to say this, but the FTSE 100 is stuffed full of value traps – unexceptional companies that are unlikely to compound in value over time.

It is the quality of the business and its ability to grow first and foremost that will be the key determinant of your investing success. But you can get bad results with these companies by overpaying and this risk seems to be increasing for many quality stocks right now. My view is at odds with what is going on at the moment, but I maintain that valuation does matter – eventually.

That said, I do think there are some shares within the UK market where valuations have not become excessive and where the business quality remains good. I refer to these businesses as chuggers, which can quietly grow at modest rates going forward while maintaining stable and dependable profits and cash flows over an economic cycle. I think these shares are much more attractive right now than others where the growth expectations look very high.

Quality chuggers

Source: SharePad

As you can see, very few of these shares are priced at very cheap valuations, but nor are they very excessive either. No business is completely bulletproof and many have some issues that might concern some investors. Yet, most are making good rates of profitability and still offer the prospect of future growth.

This to me looks a better hunting ground right now for quality investors and worthy of more attention.