Investing in Quality

Is the price required for quality -- the price in relation to earnings and yield -- worth it in investing? Would you rather own a $3,000 racehorse or one tenth of one percent of a $3 million racehorse? It depends.

Value investors pay a lot less per pound of horse than do quality investors.

With the $3,000 race horse you are investing, in part, in change. You are hoping that the win/loss ratio will improve. (He had a bum knee, but he now appears to be fine. And his great-great-great-grandfather won the Kentucky Derby thirty years ago). With the $3 million horse, you are investing in no change -- that current trends continue.

In the $3,000 racehorse business, qualitative factors are key -- your ability to see, or find through research, factors and information pointing to a happier future. In the $3 million racehorse business, you can run the numbers, calculate the likely future earnings, and then calculate likely breeding income. Assuming nothing changes.

Another difference is numbers of horses, or companies. There are a lot more $3,000 racehorses around than $3 million horses. If you are an analyst who studies the top one percent of low or no-debt, high long-term return on equity companies, you follow about 80 companies because of the huge number of companies with no revenue. That's quite manageable for an analyst.

There are two primary issues following those 80-100 companies. (1) Relative value based on earnings, earnings growth and free cash flow. To specialize in this area, you need to know the historic ratios to value, and buy the highest-quality companies when they are reasonably priced. Out of the one hundred, there are of course a cheapest ten and a most expensive ten. That difference is often driven by recent growth, and (2) You need to believe that in the case of a specific security,  its competitive advantage is sustainable ("moat") and basic market won't change or become obsolete (ie Buffett's investment in dominant city newspapers before the age of Craigslist. It's hard to compete with free).

The top one percent are the kinds of companies you can buy and hold for ten years, the companies Warren Buffett says he can buy and hold comfortably if the market shuts down for ten years. If, after careful research, you buy ten of them, one or two will perform poorly, one or two will be outstanding performers, and the rest will roughly track their return on capital over a long period of time (or return on equity for banks and insurance companies).

And the top one percent tend to be low volatility stocks. In the following two excellent articles, analysts advance the proposition that Buffett made his fortune levering up low-volatility, high-quality companies:

http://seekingalpha.com/article/4049808-buffett-low-volatility-investing

http://www.econ.yale.edu/~af227/pdf/Buffett%27s%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf

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* There are roughly 4,333 actively traded on exchanges in the US, and another 9,800 OTC (including Pink Sheet) traded stocks. A few OTC companies are substantial, highly-profitable companies that are closely-held with only a small percentage of the outstanding stock traded publicly.