“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results” – Warren Buffett
At RECM, our primary aim is to buy quality assets cheaply. A quick glance at the biggest positions in the Nedgroup Investments Managed Fund may cause investors to question whether some of these businesses, operating in extremely difficult conditions and under severe pressure, fit the definition of “quality”, and whether, if they are cheap, they have good reason to remain so indefinitely. This article highlights RECM’s definition of quality, and discusses why, in the absence of quality businesses trading cheaply, buying average businesses at very low prices is a better strategy than buying quality businesses at any cost.
As value investors, when prices are substantially below intrinsic value, we become interested. When a low price is associated with a good quality asset, we are even more interested. These attributes of a good investment - quality and cheapness - help us reduce the chances of suffering a permanent loss of capital. A cheap asset has a large margin of safety to cater for the possibility of our analysis being wrong; and a good quality business can grow its intrinsic value over time, thus protecting investors.
The top 10 stocks in the Nedgroup Investments Managed Fund (on a look-through basis) as at 28 February 2014 were as follows:
Quality, much like beauty, is in the eye of the beholder. The popular perception of what constitutes a “quality business” tends to change depending on what has done well in the recent past. Often, this relates to how well the share price of a company has performed, rather than to the fundamental performance of the underlying company itself. For this very reason, it is important to have permanent criteria regarding quality and to stick with this throughout market cycles, ignoring subjective measures of popularity.
At RECM we define a quality business as one that can produce returns over and above its cost of capital over time. This does not mean that it has necessarily done so at every point in its history – most companies have a cyclical aspect to their returns. At the very lowest points in the cycle, some even deliver returns below their cost of capital. However, they need to show that on a normalised basis, looking through the cycle, they have been able to earn excess returns over time and have a readily identifiable barrier to entry that protects those excess returns or will enable them to achieve such returns in future when the cycle turns. As value investors, our highest position in a quality business would intuitively be close to the lowest point in its current cycle – because quite simply, this is when it is most likely to be cheap. Unfortunately, quality businesses are seldom cheap when everything is going well.
7 out of the 10 businesses mentioned above meet our definition of quality, and many also happen to be at low (read: difficult) points in their cycle and are thus cheap. There are varying degrees of quality. A business that achieves greater excess returns and/or does so in a consistent and less cyclical manner is of better quality than one that achieves a smaller excess return and/or has a highly cyclical or volatile nature to those excess returns. Given most of the positions in our top 10 are in resource companies or in other cyclical industries such as gaming and leisure, it is fair to say that there are other businesses in South Africa with higher quality characteristics. Unfortunately however, they are not cheap today and as such, we do not own them.
In structuring a portfolio, we have to position for the best potential excess returns while protecting against the risk of permanent capital loss. In considering our two primary criteria, cheapness and quality, it is the first of these that a value investor cannot, under any circumstances, compromise on. The simple reason for this is that the price/value relationship has the biggest impact on returns. In other words, always buy cheaply. Buy quality businesses cheaply if they are available – this is first prize. However, buying average businesses at very low prices is a worthwhile strategy in the absence of cheap high quality businesses. Even in the case of what turns out to be a poor quality business, paying a low enough price will help to protect against the risk of permanent capital loss. To prove this, consider the following diagram:
Above are three scenarios for price:
- a good/cheap price at 60% discount to fair value,
- a neutral price at fair value, and
- a poor/expensive price at three times fair value.
On the other side of the equation we consider three businesses of differing quality:
- an exceptionally high quality business that is able to grow its fair value by 15% per annum or 9% above inflation,
- a business that grows its fair value in line with inflation at 6%, and
- a business that has deteriorating fundamentals and a declining fair value in real terms with 0% nominal growth.
The column on the far left represents the investment returns given the various combinations of these criteria. Ideally, one hopes to have the ability to invest in high quality businesses trading cheaply as this quite clearly gives the best possible outcome (+31% per annum). However, the poorest range of returns (-2% to -15%) is achieved by investing in any of the three businesses at an expensive price. Even investing in a high quality business that is able to grow its fair value at 15% per annum turns out to be a poor investment delivering -2% per annum if you pay an excessive price for it. Bear in mind that the highest quality businesses can trade in multiples of fair value at the top of the cycle, given the surge of interest, popularity and momentum they enjoy at this point. On the other hand, buying even a lower quality business at a 60% discount to fair value delivers 14% per annum - a real return of 8% per year.
By example, consider Arcelor Mittal – the steel producer represented in the top 10 by both the global and local companies. Based on our definition of quality, this is an average business – it has earned returns in line with cost of capital through the cycle over time, and is in an industry with very low barriers to entry. However, purchased cheaply at its cyclical lows, when negative sentiment was at its peak and the business and steel industry under extreme pressure, it has turned out to be a good investment, up 80% from its lowest price in 2013. On the other hand, a much favoured and lauded quality business like Shoprite is down 30% from its highs.
A good business is not a good investment if you pay too high a price for it – but an average business can be a good investment if you buy it at a low enough price. Ideally, we prefer to invest in high quality businesses when they are cheap. In the absence of these opportunities however, buying average businesses at very low prices is a better strategy than buying quality businesses at any price.