The Quality Enterprise

From this GMO white paper: 2004, we published our findings that investors had historically underpaid for the low-risk attributes of high quality companies. 

Later in the paper they also added the following:

The systematic valuation advantage of Quality companies is an important component of our investment thesis. While it is possible that at some point Quality could become universally overvalued, we currently view that as unlikely because so few market participants adhere to our Quality framework. Meanwhile, academia continues to promulgate Modern Portfolio Theory, ensuring a steady supply of new market participants who follow the logic that risk is necessary for outperformance.

Basically, the paper makes the case that market participants have historically overpaid for high risk and underpaid for low risk and provides solid backup for their view.

Contrary to Modern Portfolio Theory (MPT), historically the lower risk companies outperform the risky ones and the market has systematically undervalued them (the early 70s and late 90s are two time periods I can think of when many became much more than fully priced). It's an insight often not used (by pros and non-pros alike) even though the evidence to support it is not tough to find nor does it require some kind of complex analysis.
(By the way it's not exactly easy to convince someone of this. I've had modest success at best over the years. In my experience the typical response to it has been: "There has to be more to it!" Well, there really isn't.)

Companies with durable profitability, those all too frequently referred to as "defensive", provide more "offense" than market participants seem to think. These businesses just happen to do it at lower risk.

The above may trash MPT, deservedly so, but the paper strongly embraces the best ideas from the microeconomics of oligopolies. The best companies among what are essentially oligopolies can legally create barriers to normal competitive forces. That creates above average long run returns. Not exactly groundbreaking stuff. It just, for whatever reason, seems to be underestimated or at least underutilized. The reasons why are less important from a practical standpoint. What does matter, practically speaking, is it has historically led to mispricing on the low side.

Some may remain dedicated adherents to the competitive equilibrium model but it's either limited or totally flawed depending on your point of view. Businesses, according to that model, are destined to have their profits revert to the mean. Well, in general, oligopolies DON'T REVERT.

A flawed or limited idea misapplied can be very costly.

The highest quality enterprises, those with a long track record of high return on equity (ROE), have a tendency to continue producing above average returns.  Their profitability is persistent with long-term effects and outcomes not as difficult to foresee as some might imagine. Of course one has to take more risk to get more return, right? Nope. The evidence strongly supports that these companies produce higher returns at lower risk over the long haul. While this may go against conventional wisdom, it has the great benefit of sound reasoning and plenty of evidence to support it.

There's hardly a guarantee the above will remain true going forward but, in the context of the risks one must take when investing in common stocks, it's a very useful insight.

Just about as good as one can ever reasonably expect when it comes to investing in stocks.

Unlike many of my earlier posts on this subject, I happen to think shares of the highest quality businesses are not exactly cheap these days (they're merely not very expensive).* Still, with enough patience and discipline (buying shares of what you understand when selling at a clear discount to value), long run returns relative to the risk tend to be very attractive indeed.

I'll follow up on this in another post.


Related posts:
Consumer Staples: Long-term Outperformance, Part II - Dec. 2011
Consumer Staples: Long-term Outperformance - Dec. 2011
Grantham: What to Buy? - Aug. 2011
Defensive Stocks Revisited - Mar. 2011
KO and JNJ: Defensive Stocks? - Jan. 2011
Altria Outperforms...Again - Oct. 2010
Grantham on Quality Stocks Revisited - Jul. 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov. 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr. 2009
Best and Worst Performing DJIA Stock - Apr. 2009
Defensive Stocks? - Apr. 2009

* With any investment, no matter how seemingly attractive, margin of safety is all-important. What's sensible to buy at a price that represents a nice discount to intrinsic value doesn't make sense at some materially higher valuation. Margin of safety protects against the unforeseen real, even if fixable, business problems. Still, it's worth considering this: "If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." Charlie Munger at USC Business School in 1994
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The Quality Enterprise
The Quality Enterprise
Reviewed by jembe
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