OCTOBER 2019

Quality and "The Middle Way" of Investing

Category: Investment Research, Managing Directors, Senior Management

Erick Rawlings Athena CapitalBy Erick Rawlings, Managing Director, Research

The Athena Capital Research team has immersed itself of late in the idea of quality investing. Although the exact definition and execution of quality varies across investment managers, its underlying thesis may be explained by comparing it to the more well-defined styles of value and growth.

First, to level set the hypothetical scenarios:

  • The comparisons use the simplistic relationship between the price-to-book (P/B) paid by an investor and a company’s return on equity (ROE). An investor earns the company’s ROE if the P/B paid at entry and exit is the same, while an investor’s capture of the ROE, and thus the total return, is enhanced/impaired by exiting at a higher/lower P/B multiple.
  • To make the examples and math simple, the scenarios assume no write-offs, dividends, or other factors, such as intangible influences, that affect a company’s ROE or book value.

Now, on to the show.

Example 1: The Value Opportunity

If you buy a company at 1x P/B, and then sell it five years later at 1x P/B, you will earn the company’s ROE, which in the example below is 5%. If the multiple expands to 2x when you sell it, you in effect earn a 20% annualized return which is the combination of the company’s ROE plus the annualized expansion of the P/B multiple. This high return potential represents the allure of value investing—finding the proverbial dollar for fifty cents. But this upside must be weighed against the risk of at best earning just the company’s ROE. For context, the average ROE of the S&P 500 is around 10%, so holding P/B constant in both instances, earning 5% versus 10% would cost you a cumulative 33% over five years. Said differently: be mindful of what you get for what you pay.

Example 2: The Growth Opportunity

Conversely, if you pay 5x P/B for a company with an exceptional ROE of 20% and you sell it in five years at 5x P/B, you will earn the company’s ROE of 20%. But the ROE holds, you end up with an annualized return of 10%. But at 5x P/B, there needs to be a high degree of conviction that that ROE won’t fall toward the market average. For example, if that exceptional ROE declines to the market average of 10%, your best case is that the P/B stays at 5x and you at least earn the reduced 10% ROE. But an average 10% ROE shouldn’t command an above market P/B. In the instance that the ROE falls to 10% and the P/B falls to 3x, the annualized return is 10%. This outcome would be even worse were an investor to invest in a company that promises future profits but they never materialize and therefore generates a negative ROE. In that instance an investor suffers both the multiple contraction and the negative ROE. Which is to say: be mindful of what you pay for what you get.


Example 3: Quality, or "The Middle Way"

Let’s say you find a company that has an above average ROE of 15%, and you pay a fair multiple for it of 3x P/B. For context, the S&P 500 P/B has hovered around 2.5x for the past 20 years, on average.

With quality managers, underwriting the durability of the above average ROE and paying a fair price are the key factors. In terms of assessing the ROE, the approach varies across investment managers, who most often focus on evaluating some combination of the economic moat of the business, the trajectory of that moat, the industry structure, the alignment of management teams, the management team’s history of capital allocation, and corporate culture alignment to strategic positioning. But the underlying key is to find those businesses that the market thinks are going to see their ROE revert to something close to a market average, but because of the company’s moat dynamics, it outperforms.

Once the quality business is found it is about being disciplined on paying a fair price as a means of providing a margin of safety.

In the scenario below, similar to the prior examples, if you sell your position in a company at the same multiple as you bought it (3x P/B), you will earn the company’s ROE (15%).

But let’s say the multiple expands to 4x, you will enjoy a 21% annualized return, while if the multiple contracts to 2x, you still eek out a positive return of 7%.


But a company with a durable, above average ROE shouldn’t trade at a P/B discount to the market for long. Therefore, with proper underwriting, a quality ROE business offered at an attractive discount to the market can present a tremendous compounding opportunity. The chart below reflects the return potential of the same 15% ROE business but bought for 2x P/B. Were the company to trade back to its previous 3x P/B you end up with a near 25% annualized return.

And here’s the real kicker: that valuation tailwind compounds in your favor indefinitely. That is, a quality company bought right and held will create a compound advantage for as long as the company and ROE remain exceptional.

I liken this phenomenon to launching satellites into orbit. That is, these exceptional compounding opportunities don’t happen often, they take a lot of work to prepare, but once successfully executed and launched, the compounding orbit can be exceptional.

This scenario is represented in the chart below where the blue line represents buying the 15% ROE company for 2x P/B, while the yellow line represents buying the same 15% ROE company for 3x P/B. If, in 30 years*, the company trades at 3x P/B and you paid 2x P/B at entry, your annualized return is 16.4%. If you paid 3x P/B at entry you will have earned the 15% ROE. That 1.4% annualized delta (16.4% minus 15%) doesn’t seem like much, but after 30 years, $100,000 invested at 15% turns into $6.6 million, while compounding at 16.4% turns that $100,000 into $9.5 million.

A Quality Example:

The above has all been theoretical—but what about in practice? I’ll use a popular quality manager position, Visa (V), to help demonstrate our point.

Visa, a multinational financial services corporation, held its IPO in the challenging markets of 2008 and saw its P/B ratio trade down to 2x and then rose to 2.5x by mid-2012. Visa’s ROE at the time was ~15%. For comparison, the S&P 500 traded around 2x P/B from 2010 through 2013, and had ROE between 10% and 13%.

Let’s say you bought Visa at 2.75x P/B in 2009 on the expectation that the migration to credit card/check card payments from cash/physical check would continue and on the belief that Visa and Mastercard held strong market positions (i.e., moats) in processing those credit/check card payments via their networks.

How has this played out over the past 10 years?

Visa’s P/B has gone from 2.75x to 9x, and its ROE has gone from 15% to 29%. Based on the simple calculation of P/B expansion and ROE (and using an average ROE of 17%), an investor would expect an annualized return of 30%. Reality: Visa has delivered a 26% annualized return over the past 10 years. For comparison, the S&P 500 has delivered a 13% annualized return. To put this in dollar terms, a $100,000 investment in Visa would be worth about $1 million, while that same $100,000 invested in the S&P 500 would have turned into $340,000.

 

* 30 years acknowledges research by GMO that suggests abnormal profitability decays to something close to average around 30 years. See Ben Inker’s “Bigger’s Been Better” in GMO’s 2Q19 quarterly letter.

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