Why investors in ‘quality’ are headed for a fall

It seems everyone these days only wants to buy ‘quality’. Quality investments are all the rage. Which makes sense. Of course you should aim to have quality stocks in your portfolio.

But what a lot of investors are ignoring is the price they are paying for quality. Remember the Nifty50 bubble of the late 1960s and early 1970s? Everyone thought you couldn’t go wrong buying quality large-caps — stocks like IBM, Xerox, McDonalds, American Express and Eastman Kodak.

And while some of these worked out to be fine long-term investments, you would have had to have nerves of steel or complete ignorance to hold on.

In this wire, I’m going to explain why paying a high price for a quality stock will lead to mediocre long-term returns.

But first, a caveat…

If you’ve bought these companies at a fair price, sitting tight is the way to go. Thinking you can take some profits and buy back in when prices fall is a low-probability strategy. Plus, there are transaction costs and taxes to take into account.

So, if you’ve bought right, sit tight!

                                                       What is quality?

Now, let’s define what we mean by quality. I’m not sure there is an official definition, but I’d say it would be something like this:

‘A company that generates sustained high returns on tangible capital (thanks to a competitive moat) and compounds those returns via reinvestment.’

The US tech companies are the pin-up stocks here. They can compound at high rates of return for years because the US economy is massive, giving them a huge growth profile from start-up phase to national dominance. Then, national success often leads to global success, which offers another growth runway and compounding opportunities.

Google, Facebook and Amazon are good examples of this. And, of course, there is Apple, Netflix and Nvidia.

You also have companies like Visa and Mastercard that have huge network effects and ongoing growth prospects as society goes cashless. All these companies generate very high returns on tangible capital and significant free cashflows.

Chris Mackay’s MFF Capital Investments [ASX:MFF] is the best local exposure for quality global growth stocks. It’s one of the few investment funds that isn’t afflicted by what Buffett termed the ‘institutional imperative’. That is, bureaucracy over rationality.

His monthly commentaries are always good reading too. Take this snippet from early April:

‘Higher prices are riskier, not less, and presage lower future returns, not higher. Sentiment can change quickly, and will change eventually, as company/industry specific issues and geopolitics, elections, inflation/stagflation/interest rates assume fluctuating levels of importance for market participants, the vast majority of which are not investing in equity markets for long term exposure to sustainably advantaged businesses.’

That last bit is an important point for you to keep in mind. Although the ‘stock market’ and ‘investors’ are common word associations, you’d be wrong to believe it wholeheartedly.

The vast majority of activity on the stock market has nothing to do with investment. There’s an army of analysts, brokers, investment bankers and traders that must be fed. If everyone is an ‘investor’, meaning they buy, hold and wait, a lot of stock market participants will go hungry. Activity is the name of the game.

Don’t forget that when you’re scratching your head about share price movements. In the short-term, it is nearly all noise.

But Chris’ first comment is pertinent to this wire’s main topic: ‘Higher prices are riskier, not less, and presage lower future returns, not higher.’

That is, the higher the price you pay for a given level of earnings growth, the lower your future return will be. It doesn’t matter if the stock is a quality one or not.

Railroads and AI

I don’t know whether the big tech stocks are overvalued or not. I do know they are probably the most dominant companies in history in terms of their profitability and compounding opportunities.

The big risk factor in terms of their future value is the significant capital expenditure required to build an AI capability. What will the future sustainable returns be on this investment? Will it be like other revolutionary infrastructure, like the railroads and the internet, where excess capacity led to lower initial returns on investment?

Who will the benefits of AI accrue to? The users or the providers? The users, definitely. But will the providers over invest to stay ahead of the game? That’s the risk.

If that’s the case, and the main players compound earnings at a lower rate into the future, their intrinsic value will decline.

I don’t have any special insights into how this will play out. The main point to realise is that intrinsic value is all about the sustainable return on invested capital a company produces (and the rate at which it reinvests that capital).

As far as the Aussie market goes, we have a lot of ‘quality’ companies…just not in the same league as the tech giants.

But they have certainly benefited from the market’s renewed fervor for ‘quality compounders', thanks to the phenomenal growth of these globally dominant tech firms.

Quality Aussie Compounders

Let’s have a look at a few of them now and see what future long-term returns ‘investors’ can expect by buying at current prices.

Remember, by ‘quality’ we’re looking for companies with high returns on tangible capital, with preferably the opportunity to compound these returns through high levels of reinvestment.

But how do you estimate future long-term returns? Short of plugging growth estimates into a discounted cash flow model and working out the implied discount rate (which would be the expected return) there are a few rules of thumb.

The more well-known one is to invert the P/E ratio and turn it into an earnings yield. So a stock on a P/E of 20 trades on an earnings yield of 5% (1/20)

Another way to assess the earnings yield, and make comparisons across businesses easier, is to adjust for differences in debt and tax payments. You do this by using EBIT (earnings before interest and tax) as your earnings proxy and EV (enterprise value, which is a company’s market cap plus net debt) as the price proxy.

The earnings yield of a company thus becomes EBIT/EV

Using this formula (and consensus estimates for FY25) here is a list of large and mid-cap ‘quality’ stocks and their earnings yields:

Wisetech — 1.8%
REA Group — 3.6%
Cochlear — 2.9%
Pro Medicus — 1.3%
Netwealth — 3.3%
Lovisa — 4.4%
PWR Holdings — 3.8%
Car Group — 4.2%

Wisetech is the standout here. Pre-tax operational earnings forecasts for FY25 represent an earnings yield of just 1.8%.

That’s ok…it’s a growth company!

Let’s assume pre-tax profits double. That gives an earnings yield of 3.6%. And if they double again, that takes it to 7.2%. But the ‘investor’ only receives earnings after the tax man has grabbed his share. So, after tax, you’re still only looking at an earnings yield of around 5%, and that’s after I’ve heroically assumed earnings growth of 4x from here.

You can get a term deposit for that with very little risk!

You can do similar math with the other stocks on the list. And keep in mind it is no easy feat to double profits. For larger growth companies, it takes years to do so.

What’s good is bad

Yes, these companies are ‘quality growth’. But quality and growth have become so popular that they are now more a speculation on future share price growth rather than an investment based on traditional risk/reward characteristics.

In investing, what’s popular almost never works in the long-term. What feels good now will almost always feel bad in the future.

The message is simple, don’t pay any price for a company, even the good ones. Use basic rules of thumb (EBIT/EV) and common sense to understand what you're really getting when you buy.

Based on my small sample above, a lot of investors are locking themselves into poor long-term returns by jumping on the ‘quality growth’ bandwagon.

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