23 April 2024 Unpacking the qualities of quality investing - By efpc
One of the most thought-provoking insights into quality is found in Zen and the Art of Motorcycle Maintenance, where Phaedrus tells his students that “even though quality cannot be defined, you know what quality is”.
This sentiment strikes a profound note when it comes to investing. While value and growth interpretations may align, when defining quality a spectrum of views is revealed. Characteristics frequently associated with quality include strong leadership, esteemed brands, and potent pricing power. Interestingly, even Benjamin Graham, a trailblazer in value investing, grappled with quality’s definition in the 1930s, when stocks were categorised as either Quality or Low Quality. In today’s context, three key attributes typically signify quality: Consistent and predictable cash generation; superior returns on capital; and compelling growth prospects. In essence, quality harmonises when robust growth resonates with superior returns, encapsulating all of the aforementioned attributes.
The timeless debate around superior investment styles – value, quality, or growth – continues to be the investment world’s equivalent of comparing apples, oranges, and bananas. We believe that the true value of this discussion lies in aligning your investment approach with your specific objectives and global economic perspectives. At Efficient Private Clients, we refrain from endorsing one style over another, recognising that each may shine under different market conditions and phases of the economic cycle. Numerous investors have excelled across diverse styles, from Seth Klarman with value investing, to Terry Smith, who adopts a quality-based approach. It is, therefore, essential to understand that no strategy exists in isolation.
Since the global financial crisis (GFC) in 2007/2008, quality investing has emerged as the North Star that guides many through turbulent economic times. This surge in interest can be attributed to the defensive attributes of high-quality companies, which tend to cushion portfolios against abrupt market downturns. In an era marked by heightened market volatility, exacerbated by events like the GFC, the COVID-19 pandemic, and recent spikes in inflation and interest rates, investors increasingly seek assets with the resilience to navigate turbulent times. Moving forward, this trend is expected to persist in an environment marked by highly leveraged economies and companies, as well as structurally subdued growth. Furthermore, it is noteworthy that in the 25 years leading up to 2020, quality investing consistently outperformed the MSCI World Index across all rolling ten-year periods.
Fortunately, there are abundant opportunities to invest in such exceptional companies within the market. A prime example of a high-quality company is Hermès. Hermès is renowned for its prestigious presence in prime global locations and is the epitome of luxury. The iconic Birkin bag, a hallmark of the brand, can command prices upwards of tens of thousands of dollars. Even a silk tie or pocket square from the Hermès collection can retail for more than $250. Notably, Hermès products are never discounted, and the waiting period for certain items can be longer than four years – this is twice as long as the waiting period for a Ferrari! What distinguishes Hermès from other luxury brands is its unique blend of scarcity and unparalleled quality, which translates into consistent and robust cash generation, superior returns on capital, and promising growth prospects.
The renowned investor Howard Marks once remarked that “it is what you pay for it that determines whether something is a good investment”. This philosophy resonates deeply with us at Efficient Private Clients. While we prioritise the attributes and reliability of a quality-based investment approach, we equally emphasise the importance of valuation and that, ultimately, dictates our buying and selling activities.
Navigating this intricate environment will require a deep understanding of how local conditions intersect with global economic trends, and a strategic approach to investment that considers both immediate economic realities and long-term prospects. This is a critical time for SA, and for those invested in its future, staying informed and adaptable is more crucial than ever.