Are quality shares overvalued?

Yet, blindly buying shares solely because they look cheap often ends badly. This is because usually something is cheap for a very good reason – it is not as good as something more expensive. Cheap investing and value investing are often two very different things. Superior long-term investment results are much more likely to come from paying more to buy the shares of good companies. 

Warren Buffett’s investing partner, Charlie Munger, sums up the trade-off between quality and price well when he says: “It’s better to buy a great company at a fair price than a fair company at a great price.” 

Back in the 19th century the prominent artist and thinker John Ruskin arguably summed it up even better: “It's unwise to pay too much, but it's worse to pay too little. When you pay too much, you lose a little money – that's all. When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do. The common law of business balance prohibits paying a little and getting a lot – it can't be done.” 

Like many things in life, paying up for quality is the right thing to do as long as you don’t pay too much. Paying a little bit more for a good bottle of wine or getting a proper piece of furniture instead of a flatpack often tends to work out better in terms of satisfaction and long-term use. Applying the same principle to investing in shares makes a lot of sense to me. 

The case for investing in the shares of quality companies 

Quality investing involves owning the shares of very good companies over a long period of time. This essentially sums up Warren Buffett’s investing approach. The strategy has also been very successful for British investors such as Terry Smith, Nick Train and Keith Ashworth-Lord. But what does a quality company look like and why can they make investors lots of money? 

A quality business provides products or services that its customers want, but at the same time are very difficult for other businesses to copy. The company has something that protects it from competition. This might be a brand, a patent or the cost of complying with rules and regulations. Its products may also be deeply entrenched with its customers (think Google or Microsoft Office) so that switching to another one may not make sense. This is referred to in the investing world as an economic moat. 

The presence of an economic moat is a key pre-requisite of a quality business. This in turn often leads to the company having many or all of the following desirable financial characteristics: 

• Steady and predictable sales and cash flows. 
• High profit margins – typically more than 15 per cent. 
• High returns on capital employed (ROCE) – typically more than 15 per cent. 
• The ability to reinvest profits at high rates of return to keep profits growing in the future. 
• Low capital investment requirements to grow. 
• Turns a high proportion of profits into free cash flow. 

It’s relatively easy to find businesses with these characteristics by using stock screening software, but that doesn’t necessarily mean that you have identified a quality business. If you are going to follow a quality investing approach then you need to understand the business behind the numbers – what the company has that produces them – and be very confident that the financial performance is not temporary and is sustainable. 

What makes the quality approach successful is owning the shares of good businesses over a long period of time to utilise the power of compound interest. Over time, a highly profitable business investing money at high rates of return can compound into a much more valuable one. Providing that the investor does not pay too much for the shares in the first place, they should make money from a rising share price and larger dividend payments. 

Why quality shares look expensive 

The high and dependable profits made by quality businesses is what makes them valuable. Their ability to keep delivering through good times and bad gives investors peace of mind and helps them sleep better at night.  

These businesses are arguably less risky than many others out there, which has led some to label them 'bond proxies'. They are not bonds. In many ways they are better, given their ability to keep growing profits for their owners. That said, shareholders are still the last in the queue to get their hands on a company’s profits and this is what makes them riskier than bonds. 

However, it makes perfect sense for the profits and cash flows of high-quality companies to be highly valued by the stock market. You wouldn’t expect to buy a vintage bottle of wine for the same price as a bottle of plonk and the same reasoning applies to quality shares. 

But are they now too expensive? 

Source: Capital IQ. Share prices as of 30 August 2018 

I’ve taken a selection of quality shares owned in Terry Smith’s FundSmith Equity (GB00B41YBW71) and Nick Train’s Finsbury Income & Growth Trust (FGT). As you can see, many of the companies are making a lot more money than they were a decade ago. But in many cases, their share prices have increased a lot faster than their profits as measured by earnings per share (EPS). 

With the exception of Philip Morris and Novo Nordisk, the shares are trading on much higher PE ratios than they were a decade ago. Put simply, their share price performance has far exceeded their underlying business performance. Is it reasonable to expect this to continue? 

Source: Capital IQ 

If we look at analysts’ forecasts for the next three years then the general outlook is for modest rather than very strong growth in profits. Of course, there is a possibility that these forecasts will be beaten, but in the absence of a further re-rating – an increase in the PE ratio – it looks as though it will be difficult for some quality shares to deliver the stellar returns to their shareholders that they have done in the recent past. 

Source:Capital IQ 

This view looks to be strengthened by comparing the PE ratios with their expected EPS growth rates – the PEG ratio. In the eyes of Jim Slater who introduced this measure to investors in his book The Zulu Principle, a PEG ratio of less than one was attractive. Nothing comes close to that in our list of shares below. 

Source:Capital IQ 

That said, I still see a strong case for owning these kinds of shares and the funds that own them. I think in many cases, they will continue to be backed by a strong and resilient business behind them that will ride the ups and downs of business and stock market cycles better than most.  

I also strongly believe that the stock market tends to undervalue quality businesses and their shares over the long haul. Above all else, this is because they are relatively scarce, which means that they are likely to remain desirable to own. A very good recent example of this is the takeover of Fidessa, a financial software and services company that had proven to be highly profitable over a long period of time. Despite looking expensive – or not particularly cheap – like many of the shares above it was eventually bought for a very high valuation that represented a big premium to its previous share price. 

Quality investing is unlikely to make you rich quickly, but is arguably one of the best long-term risk/reward strategies for buy-and-hold investors.