OVER the last year or so, you may have noticed a growing investment debate over whether shares with quality or value characteristics are the better choice. While the implication that one would ever seek to invest in something that is not quality or does not represent value may seem surprising, the debate essentially revolves around the concept of whether an investment is cheap or expensive and how one goes about making such a subjective judgement.
One of the most important elements of this debate is an exploration of risk aversion and how this can affect share prices. Imagine you are invited to wager money on the flip of a coin. If it lands heads you receive £100,000, if it lands tails you lose your wager. How much would you be willing to bet? I would imagine substantially less than £50,000 – even though this is the average outcome of the game (if it were repeated ad infinitum) and represents the par wager for a risk-neutral investor with unlimited means. But most people are risk averse so would only bet a much more modest amount, even with the attraction of a potential £100,000 payday.
Applying this principle to investing in companies, to buy shares in a business with uncertain prospects you might pay less than for a very similar company with greater visibility over its profits. Such differences in valuation can lead to companies appearing to offer value or, conversely, trading on higher valuations to reflect their higher quality.
Which investment approach you believe yields the best results depends very much on your investment philosophy, but we agree with Warren Buffet’s statement that “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
The debate we referred to earlier revolves around the idea that shares in high-quality companies have performed very well, meaning that they may now be vulnerable to a correction relative to value stocks.
We do not share this concern. One problem with value investing is that the most widely used method of valuation - the price-to-earnings ratio - depends heavily on earnings. With value stocks particularly you cannot really be sure about the earnings. Objectively, companies on low ratios according to forecast earnings may look pretty cheap, but in two or three years’ time if those earnings are not in fact delivered then it will become apparent that they were not as cheap as they looked. With quality stocks, the probability of receiving the given level of earnings is much higher.
An examination of valuation metrics is less important to us than the identification of three key investment characteristics that we believe give companies an economic advantage: intellectual property, strong distribution channels and significant recurring business.
Once we have established that a business possesses economic advantage, and is successfully reaping the benefits in the form of high returns on its capital, we are comfortable to then pay a reasonably full price for its shares based on measurements such as price to earnings, free cashflow and yield.
In other words, we believe it is better to invest in a good business than an average one that appears cheap.
Julian Fosh is a fund manager at Liontrust Asset Management.
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