15th Oct '23 by Edmund Shing

17 comments 1812 reads

Market Musings 141023
The Quest for Quality

Summary:

The Benefits of Quality over the long run
Yes to Quality, but watch the price to pay
Perhaps focus on sectors outside of Tech
Approaches in Quality investing

Podcast this week:
Our investment strategy for October 2023

In this podcast Edmund Shing, Global Chief Investment Officer of BNP Paribas Wealth Management unveils his investment strategy for October 2023.

The Benefits of Quality over the long run

Much has been said about the advantages of investing with a quality mindset. Warren Buffett, one of the most celebrated investors in the world, is an avowed investor of quality stocks.There are many other investors who have been also celebrated for taking an explicit quality approach to investing in stocks such as Terry Smith, the founder and fund manager of Fundsmith.

First of all, what even is quality? The easiest definition of a quality stock is one which has:

higher than average profitability that is sustained over a long period of time, together with
relatively low levels of debt, or even net cash.

This can encompass a wide range of industries of course, but industries that come to mind as being dominated by quality stocks include

Healthcare,
Luxury Goods,
Cosmetics,
Premium drinks,

As well as selected monopolies and oligopolies, and technology

Essentially, we are looking for business models that can sustain higher than average profitability over a long period of time, together with reasonable or even strong growth levels. This depends in part on the quality of management, but perhaps more on the industry and the business model.

This is one reason why quality companies are often companies that have a very strong bond and image with their clients.

For instance, in the celebrated case of Costco, this food retailer tends to benefit its customers through low prices and in turn reinforces their loyalty, which ultimately reinforces the quality and growth trajectory of the company.

If we study the quality factor at work in stock markets, which can be done by using ETFs and indices that are based on the quality factor combining high profitability and low debt, you tend to find that you get better returns than for the overall stock market together…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Silver Moon

15th Oct '23

Good day Edmund, we had our first frost this morning but my porfolios have been frosted up for a long time now. From now on, after a couple of day taking a hard look at the 120-odd companies in my portfolios I intend to concentrate on QV among them, Value not being so much as P/E but that according to Stocko. With an eye on dividends too, I realise that if a high dividend drops then the share price must have risen or else something must be wrong. I'm unwilling to look outside those portfolios as those within are quite enought be going on with and whittling down. I also remain within the UK listings as I'm insufficiently experienced to add other countries to my ii subscription.

AdamPeck13

Thanks Edmund, very interesting.

Cuddlesticks

Thanks Edmund. I’m not sure that large healthcare are less exposed to ‘technology cycles’ than tech stocks. You only have to look at the relative performances of Big Pharma (e.g. GSK, AZ, Novartis, Pfizer, Eli Lily, JNJ) to see the challenges managing patent cliffs. It seems more feast and famine and, these days, the success of biotech acquisition strategies to me.

Rusty2

Pfizer (NYQ:PFE) are not doing at all well but Novo Nordisk A/S (CPH:NOVO B) are still soaring.

Fundsmith have made some poor decisions lately, PayPal Holdings (NSQ:PYPL) and Adobe (NSQ:ADBE) are just 2 of them. LVMH Moet Hennessy Louis Vuitton SE (EPA:MC) are not exactly going so well.

BnB

LVMH Moet Hennessy Louis Vuitton SE (EPA:MC) are not exactly going so well.

Precisely when you should be buying. (Hopefully) short term headwinds making the share as cheap as it has been for years.

Monty Carlo

16th Oct '23

The real Fundsmith shocker is Estee Lauder Companies (NYQ:EL)

My point was about the sustainability of the competitive moat i.e. it doesn't last that long in pharma.

I agree and I’ve seen all my gains since 2018 wiped out. To be clear, it is short term very annoying. But does it matter if on a long term basis the company eventually recovers equilibrium? The principle of quality investing is to ignore the short term swings that traders exploit and just own the best companies - who will all endure tough conditions at some point. Only if the market for their product, or the quality of management has fundamentally changed, should you sell. That’s why Fundsmith sold PayPal but not EL.

They sold Adobe (NSQ:ADBE) for 20% loss, since then it has gone up around 60%. Also sold Intuit (NSQ:INTU) last December, it has since bone up 50%. Has Terry Smith lost his touch?
Thought they had sold EL now?

Yes sold EL in August, bought Marriott International (NSQ:MAR).

You’re correct. My bad. Perhaps he’s unhappy with management there too. Can’t say I’m thrilled :-]

Yes, Fundsmith has sold Estee Lauder Companies (NYQ:EL) , but just look at what the valuation metrics were while it was in the fund. To be fair it was a secondary holding to L'oreal SA (EPA:OR) .

You can trace the origins of Terry/Fund Smith's process back to the days of Collins Stewart and their Quest system. I don't want to fall foul of the lawyers so I will ask readers to draw their own conclusions on the legal dispute between Holt Value Associates (acquired by CSFB) and Collins Stewart. I've used both systems and both adopt a CFROI (Cashflow Return On Investment) approach. They are useful systems, but in the end you still need to make huge assumptions on terminal growth rates etc - like a DCF you have to input assumptions for future years, well beyond this year & next which is about as far out as City analysts will publish their models. Small changes in assumptions can result in huge changes in present value.

Problem is, it isn't difficult to identify many of the holdings in Fundsmith - a Stocko screen for high ROCE will flag up many of them, and they tend to trade at a premium valuation. It then becomes a question of whether the growth will come through over a multi-year horizon to justify the high valuation - that is very difficult to judge, and requires more skills than simple financial analysis (such as "predicting the future").

There is more nuance in the "Owners Manual" (which is about as coherent as any other fund manager process), but one of Terry Smith's marketing straplines is "Don't pay too much".

If his preferred stocks are trading at expensive valuations, what does Fundsmith do about inflows into the fund? Pay too much?

Answers on a postcard to Terence Smith.

If there’s one area where Fundsmith is less reliable in its selections, it would be software. In a rare case of me outperforming a superstar fund manager, I added to Adobe and bought Intuit just as he was selling. But this thread is about quality investing in general, of which I’m an adherent, not Terry Smith. And Edmund did not instruct readers to buy Smith’s funds.

I try to keep it simple. While always checking first that ROCE, margins and debt are clear of my thresholds, I simply ask myself: “do I want to own this company long term for its quality products, defensive moat and exposure to secular growth. And would I be comfortable owning it through a difficult period economically or in bear markets”.

Funnily enough I am cautious on following Fundsmith into holdings - the fund is probably big enough to inflate the price as he buys in and depress a share price if he turns a seller.

In looking for companies with similar characteristics that are not current Fundsmith holdings I've looked at:

Fair Isaac (NYQ:FICO)
WW Grainger (NYQ:GWW)
Mcdonald's (NYQ:MCD)
S&P Global (NYQ:SPGI)
Colgate-Palmolive Co (NYQ:CL)
Rockwell Automation (NYQ:ROK)

Of couse these have some overlap with stocks that are in Fundsmith - Verisk Analytics (NSQ:VRSK) , PepsiCo (NSQ:PEP) , MSCI (NYQ:MSCI) , Procter & Gamble Co (NYQ:PG)

I also keep an eye on the the lower-rated semiconductor companies which Fundsmith avoids due to cyclicality/capital intensity:
Texas Instruments (NSQ:TXN) , Analog Devices (NSQ:ADI)

And then Intel (NSQ:INTC) is a fascinating recovery play where you could lose a few fingers. People forget Intel makes some passable graphics cards & is not completely out of the game.

Interesting choices with only one crossover to my portfolio. That could be a good sign :-)

I would be wary that FICO could be disintermediated by AI, although the market has no such concerns. When Upstart the AI-based credit scoring business was flying high on the market there were ample reports that its software was outperforming FICO. Since then, investors have turned their attention to the new entrant's weak balance sheet. Equally, FICO could embrace AI to dramatically cut costs.

McDonalds is at a low valuation next to history but is depressed by fears over Wegovy and the fall in consumer staples over bond yields. Are the weight-loss drug concerns justified? If not, good entry today.

Rockwell is cyclical to an abnormal level next to automation competitors. I prefer and own large (for me) stakes in Schneider Electric and Eaton. Keyence is even stronger and very depressed relative to history. Can you handle a PER of 35x in return for EBITDA margins in excess of 50%? Now that's quality! No comment on Colgate, but Grainger is a beast!

My pick of your six would be S&P Global. Just look at the very long term record of shareholder value creation, huge moat, and some of the best operating numbers you'll see anywhere. Not expensive relative to historical norms today. I have a large and enduring position.

I was in there with you on INTU but I'm afraid I'm not such a fan of Adobe (NSQ:ADBE) .

I am a keen photographer, and certainly amongst the amateur/semi-pro market they have quite a resentful clientele since they forced everyone across to their Creative Cloud subscription model and many people are looking for alternatives.

I find Photoshop does more than I need, and I can make do with open source GIMP when I need layers. For RAW files I prefer to use Canon's own DPP. I hear good things about Capture One.

Difficult to tell whether AI is friend or foe for Adobe - I can see some of the AI image generators taking a share of the pie at the low end where people are happy with "good enough".

Then you have the incursion of smartphones with their built in software tricks.

As for pdfs, I edit them for free using LibreOffice....

So I don't really have much faith in the "moat", although I concede they are dominant in the commercial space.

I'm a keen photographer also. Photoshop, I don't use the cloud version, just CS6 which is on a disk. I also use Topaz which is good for noise, B&W and a few other things. Nik Efex is available free, just started to use that. If starting now, I doubt I would subscribing to Photoshop.

I did holdAdobe (NSQ:ADBE) but sold out now, thought Fundsmith would have held on to it for longer, think was at a bad time after big losses on PayPal Holdings (NSQ:PYPL) etc.

Pat W

19th Oct '23

Thanks, really interesting . I love the last paragraph.

Market Musings 141023: The Quest for Quality

Market Musings 141023
The Quest for Quality

Summary:

Podcast this week:
Our investment strategy for October 2023

The Benefits of Quality over the long run

Unlock the rest of this article with a 14 day trial

About the Author

Edmund Shing

17 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...

Market Musings 141023: The Quest for Quality

Market Musings 141023The Quest for Quality

Summary:

Podcast this week: Our investment strategy for October 2023

The Benefits of Quality over the long run

Unlock the rest of this article with a 14 day trial

About the Author

Edmund Shing

17 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...

Market Musings 141023
The Quest for Quality

Podcast this week:
Our investment strategy for October 2023