In the school of value investing, there are two broad investment styles: the deep value style espoused by Ben Graham, Philip Fisher and the young Warren Buffett; and the quality-biased style for which Charlie Munger and the old Warren Buffett are best known. Some investors will favour one style over the other, while other investors may prefer to mix it up. At Montgomery Global, we follow a value investing philosophy with a quality overlay, but we are very careful about how we define, assess and value “quality”, for reasons which we explain below. So, what do we mean by quality, and when can it be detrimental to performance?
The most widely adopted, and thus generic, definition of quality is a business that (re)invests substantial amounts of capital at high rates of return above its cost of capital. As a definition that might appear in a dictionary, it is adequate; as a key investment criterion, it is wholly insufficient. This generic measure of quality merely describes a business where profit divided by invested capital is a high number, but does not explain how or why the business has high returns. It is equivalent to saying, “Bill Gates is successful because he is wealthy”. Investors should care less about the fact that a business generated high historical returns, than the how and why behind those returns.
The equivocation of quality with high returns on invested capital means that this measure of quality is necessarily backwards-looking. We can say with certainty that a business has generated high historical returns, but investors are rarely rewarded for identifying high quality businesses of the past. Therefore, not only must an investor understand how a business generated high historical returns, but also why those high returns might persist in the future. Even great investors like Buffett sometimes conflate a business that was high quality with a business that is or will remain high quality, for example with his investments in IBM and Coca Cola through the years. We learned a similar lesson from Foot Locker: while we had justifiably high conviction that Foot Locker was a high quality business, we failed to fully appreciate the factors that could impair Foot Locker’s future business quality. (Perhaps there was also some confirmation bias, as we had convinced ourselves of Foot Locker’s high quality even as we were shorting other footwear retailers.)
Another problem with defining a quality business as one that generates high returns is that it confuses cause and effect. A business is not high quality because it generates high returns on capital; a business generates high returns on capital because it is high quality. The former framing is dangerous because it makes quality the output – once the investor has established a business’ historical return on invested capital (a quantitative measure involving no judgment), it may be tempting to jump to the conclusion that the business is high quality and thus forgo more rigorous analysis. The latter framing is preferable as quality is the input – high returns are a signal of a potentially high quality business, which then requires a rigorous qualitative assessment of what makes the business high quality, and why it generates high returns.
Finally, an emphasis on quality must always be caveated by price, as no amount of quality can make up for overpaying for a business. It can be tempting, especially when markets are elevated and opportunities scarce, to hold on to high quality businesses at prices in excess of their value. The other temptation is to use quality to justify a higher valuation, which typically happens when an investor substitutes a shallow assessment of quality for an actual variant perception.
There is a real risk of using “quality” as a labelling device to absolve a lazy investor of doing the legwork to determine what actually makes a business high quality. It is far less taxing on the brain to throw around the term “high quality business”, cross-check against historical returns and move along, than it is to think deeply about the multitude of factors that enable a business to earn high returns on invested capital in the past, present and future. To avoid using quality as a crutch, it is important for investors to clearly understand what factors have enabled, and will enable, a business to earn returns well above its cost of capital. High returns on invested capital are just a numerical manifestation of what makes a business high quality.