Having described in the previous part what we mean by high quality investing and how we could find these companies, I think it is also important to explain what the evidence for the outperformance is, and in the second part to divulge the little secret of investing – compounding at book value.
Amos Tversky and Daniel Kahneman developed the Prospect Theory and put the basis of behavioural economics in the 1980s. After Tversky death in 1997, Daniel Kahneman received the Nobel Premium for Economy in 2002.
The Prospect Theory describes how individuals assess in an asymmetric manner their loss and gains perspectives. Contrary to the expected utility theory, which models the decision that perfectly rational agents would make, the Prospect Theory aims to describe the actual people’ behaviour. In short, as explained in the ‘Thinking Fast and Slow’ book, which is an International Bestseller, most people are under- or over-weighting probabilities, which should not be mistaken with overconfidence (under- and over-estimating probabilities).
Tversky and Kahneman concluded that people will show a (1) risk adverse behaviour when gains have moderate probabilities or losses have small probabilities (near certain events), or (2) risk seeking behaviour when losses have moderate probabilities or gains have small probabilities (gambling). People attach a different psychological importance than a rational person.
In investing, the near-certain bit (around 90% probability) is the world of low beta/high quality stocks. They have bond-like returns and low stock price volatility, and as a result these stocks are known by the name of bond proxies. It is the investors’ avoidance of bond proxies, and their attraction to stocks with high beta (stocks which have high expected returns but with low probability), which leads to the bond proxies’ outperformance. Unfortunately, investors have no way to determine which high beta stocks will give them that high expected return, as it is nearly impossible for them to figure out beforehand which business will rerate or will be a turnaround, and which will be a ‘value trap’, and the vast majority of investors in high beta stocks will not beat the market.
In short, investors overpay for high beta stocks and underpay for the bond proxies. This explains why ‘boring’ high quality stocks tend to remain consistently undervalued, and that undervaluation is what helps to produce superior performance.
As a reminder, bond proxies is a shorthand to describe equities like consumer staples (PepsiCo, Clorox, or Unilever), or some tech companies (like Microsoft or Adobe) which sell goods and services consumed at short and regular intervals (sometimes by subscription). Their products and services are characterised by resilience, a resistance to product obsolescence.
There is another investor behaviour that leads to the avoidance of high-quality companies, as many investors do not know the ‘little secret’ of investing and they tend to chase high dividend companies.
First and foremost, it is not a secret, it is a misunderstanding on how compounding works when investing, and the huge difference in investment performance between companies which could grow and would retain a lot of their net earnings to reinvest in their business, and companies which pay out most of the earnings as dividends. Even if the ‘dividend investor’ reinvests the dividend in the same company stock, he/she will get a lower investment performance.
For example: both A and B companies are average companies (earning 10% on capital employed i.e. the cost of capital) and they both trade at 20 times their earnings, and earn $5 per share, based on a share price of $100. Both companies trade at 3 times their book value, so as a result their book value is $33.33/share.
Company A pays all earnings as dividend and the investor reinvests the entire dividend (assuming no taxes). Assuming fractional shares could be purchased, he/she will own 1.05 shares worth $105. The first handicap is that dividends are taxable in the hands of most investors.
Company B decides not to pay any dividends this year and instead reinvest its profit as it could grow its business. As a result, its book increases to $38.33/share. Assuming the 3 times multiplier has not changed, the Company B’s shares would be worth now $115, so the investor in company B would have made $10/share more.
This is how it works for an average company, but what if these companies are not average companies, and instead they are special i.e. they are high quality companies with a Return on capital employed (ROCE) higher than 15%, companies which can grow their business by reinvesting profits, and they trade at 5 to 7 times their book value? It means that every $1 of net earnings reinvested back into the business is worth $5 to $7 for the investor.
Warren Buffett has not paid out a dividend since 1966. He said later, in 1997: ‘I must have had a few more glasses of wine the night before the AGM, otherwise I would not have agreed to the dividend payment’. Warren Buffett realised earlier in his carrier the power of compounding at book value. In fact, up to 2019, when he agreed for some stock repurchases, no more money was paid out from Berkshire Hathaway to investors.
This is a feature of equities which no other asset class possesses. A portion of the net earnings or sometimes all the net earnings are retained and automatically invested on the clients’ behalf. As explained above, this creates more value than you can ever capture by reinvesting dividends - except, of course, when the reinvestment is done badly with the management investing when returns are not adequate.
It is not a feature of bonds or property assets. Investors receive interest or rent from these investments, but they are not reinvested for you. This advantage of equities is magnified if instead of investing in an average company you invest in a company with a higher than average rate of return on capital.
At N2 Asset Management we avoid investing in property assets, including REITs, and companies which pay out most of their net earnings as investments, like utilities. We also avoid average companies and only invest clients’ funds in high quality companies, companies with a high ROCE and high barriers to entry, which can still grow their business.
To read the first part: https://www.n2-am.com/post/why-quality-investing
If you want to discuss your wealth planning requirements, a second opinion on your investment portfolio, or how to apply your ethical values to your investments, please get in touch.
IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested