I’ve been investing since 1996 and during this time, my investment DNA has evolved from a primarily spreadsheet, number-crunching quant jockey to today where I still play a spreadsheet geek role, but now my decision factors many other variables, behaviours and observational queues . I think it has made me a better investor. Over the years my investing ideology has evolved to focus on identifying companies that have competent stewards that have demonstrated a competency to manage their entrusted capital efficiently so that they can generate tangible wealth and to invest in those companies that are selling at a discount to their perceived value. This has been my guide through many a bull market, bear market, asset bubbles and financial crises and it has served me well.
One day I looked at this description of my investment ideology and it dawned on me that this ideology that I practice day-in and day-out could be summed up better and then it hit me. My investment ideology can be best summarized in one word:
They say in real estate that the key mantra or ideology that reflects quality is location, location, and location. In investing, I’ve come to realize that out of the many ideologies, strategies, and analytical techniques available to us, successful investing comes down to putting our money to work in high quality investments.
Quality is a very subjective thing. We could a put BMW in front of us and your standards of whether the car is of high quality is will likely be different from mine. Another factor that’s important is that a quality investment represents (remember we’re being subjective here) in my eyes the best of the best. Why would I want to allocate my hard earned savings to assets that are mediocre in nature? I very much strive to ensure that when I look down my portfolio that the investments that are in there are top shelf and will give me the best chance of earning meaningful returns.
Carl Richards of Behaviour Gap fame eloquently captured this dynamic in a posting about consideration of spending more up front on high quality items can actually save you money in the long term. I've seen the value of this in how I consume goods and I can see how this approach can be carried over to the investing domain.
Quality smooths the ebbs and flows of market uncertainty
A great feature about owning high quality investments in your portfolio is that while not resistant to price shocks or periods of stock market malaise, the rate it goes down is less and also more importantly the ability for a high quality stock to recover is much higher. This is consistent with a core goal of investing which is to preserve capital as effectively as possible when stocks are out of favor and prices are depressed.
Investing in quality works well at an individual stock level. You can buy stocks and companies that are tangible. You know what they do. You can see it. Finding quality becomes a challenge when you jump to the more passive oriented Exchanged Traded Funds (ETF’s) side. When you buy an investment product that passively invests in a basket of companies like an index fund or an Exchange Traded Fund, quality can get buried and overwhelmed by stocks that are not of the same ilk. In my time working as an investment analyst and analyzing companies within large indexes, I found that in a typical year, ½ the companies within an index would be creating positive tangible wealth while the other ½ would be destroying shareholder wealth. This ratio would adjust up or down 5-10 percent but it was always in that narrow range. It’s important to understand this if you believe in ETF’s because you need to realize that about ½ the companies in an index fund are not high performing and high quality. They are there because they meet certain technical, regulatory thresholds (market capitalization, trading volume) which do not necessarily reflect quality.
What constitutes a high quality investment?
I believe that high quality investments have the following characteristics (and here I’m referring to individual stocks and the companies behind them):
- Contain a governance structure with strong management competencies that enthusiastically accepts its role as a steward of other people’s money. They take that responsibility seriously and it is infused in the culture of the business.
- They own a dominant or significant position within their industry and business lines.
- They have the ability to set prices on their products and services on their own with little external pressure.
- They produce products and services that society wants and will repeatedly purchase again.
- They can finance themselves internally without depending on external markets to issue debt or equity.
- Their sources and uses of capital (i.e. Balance Sheet) are clean with minimal intangible assets and has manageable levels of debt.
- Consistently generate Returns on Capital that are in excess than their cost of capital. They create tangible wealth on the capital they invest.
When to buy quality
If you noticed on my list of characteristics of quality investments, I didn’t include price. High quality businesses will often sell at a premium. So sometimes as much as you want to get a bargain, you may have to resign yourself to paying a little extra for a quality stock. That being said, quality companies do go on sale if there is a negative sentiment on a stock at the company or overall stock market. Quality stocks can get mispriced. It’s important to be able to identify these quality companies well in advance so when they do go on sale, you can execute and pick them up systematically and without emotion clouding your judgement.
When to sell quality
Selling a high quality stock should follow the same parameters of selling any type of investment. Selling is appropriate when an investment has reached a return level that you are seeking. If you end up selling a quality stock because it has crossed a threshold you were seeking, keep it on your watch list because who knows the market may misprice the stock again in the future and an opportunity to bring it back into your portfolio could be at hand, assuming the fundamental characteristics we’ve highlighted above are still in full effect. Another sell moment for a high quality stock would be if the company has experienced a negative game changer moment has threatens the long term viability of a company.
For me, every investment decision I make revolves trying to answer the question of whether this company and their stock is high quality. I’ve come to realize that investing in high quality assets is the best and less risky way to build wealth and also to preserve wealth over a long period of time.