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The Quality Trade

By: Pascal Duquette

Just because a company is considered to be a good company, doesnʼt mean it is worth investing in. Pascal Duquette, of Natcan Investment Management, discusses the question ʻIs the stock of a good company a good stock to own?ʼ

The question ʻIs the stock of a good company a good stock to own?ʼ, has been a recurring investor preoccupation as far back as one can remember. It has served as the basis for an investment theme often referred to as that of the one-decision stocks. The financial press has even created expressions to describe the phenomena – The Nifty Fifty stocks in the ʼ70s, the Four Horsemen in the ʼ90s, and Warren Buffetʼs cultish following.

To shed light on this enigma, one must first determine the operational definition of what constitutes a good company as well as the investment definition of what is a good stock. Only then, can one compare and contrast both elements to reach a conclusion.

Several attempts to define a good company have been published in popular books. One approach involves reverse engineering – that is looking for characteristics of the best performing stocks and identifying common factors. Tom Peters follows this path in his book In Search of Excellence.1 Other authors, such as Jim Collins in Good to Great,2 use interviews with management to identify success factors. A third approach is ground in business and economic theory as is the case with Harvard Universityʼs Michael Porter in Competitive Strategy: Techniques for Analyzing Industries and Competitors.3

The main shortcoming of all these approaches is that we are left with broad strategic statements which are difficult to translate into practical and useful guidelines. The following factors emerge as defining elements of good companies.

Elements Of Good Companies

Good companies are global operators. They reflect upon and act on global challenges and opportunities. For instance, everyone needs a strategy to deal with the effect of Chinaʼs emergence as a global economic power even if it is for defensive reasons.

They are not protected by trade barriers or local procurement laws which force them to be competitive in a global environment.

They are not subsidized heavily by their home country governments or dependent upon them for significant share of revenue as subsidies can disappear and contracts be taken away such as in the case of the defence contractor industry.

They are not unduly nationalistic as was the case of the American auto industry upon the first arrival of Japanese automobiles.

These companies possess competitive advantages. They may exploit local niches, but can compete with the best in the world within their core activity. They are globally competitive even though they operate on a local market. RONA is a good example in the do-it-yourself retail sector. These companies possess strong business franchises such as brand names or unique ways of doing business as is the case for LʼOréal, Nestlé, and Canon.

They are low cost producers with dominant market positions. The obvious examples in this category are Dell, Wal-Mart, and Costco.

They master core skills which are key success factors at the industry level. YUM brands (KFC and Taco Bell restaurants in China), Kurita Water (purified water for the semi-conductor industry), and Varian Medical (radio therapy technology) immediately come to mind.

Good companies display managerial excellence. They manage with a long-term perspective. Nestlé has demonstrated this over its 125-year history.

They benefit from strong corporate leadership as in the case of Akio Horita, founder of Sony.

Strong Business Ethics

They demonstrate strong business ethics, contrary to Enron and Tyco.

They have lean structures and shun bureaucracy. Canadian National Railways is a prime example of a corporation which evolved from government bureaucracy to become a recognized leader in efficiency.

They maintain clear corporate focus. Novo Nordisk has a stated objective of being the best diabetic care company in the world.

They operate attractive businesses. Their core activity is recession resistant and generates cash which enables them to capitalize on opportunities in difficult times. They benefit from high barriers to entry as with the case of Microsoft – a virtual monopoly.

They have growing sales and volumes.

They have greater industrial power than their competitors and suppliers. Wal-Mart has the economic might to capture the operating efficiency improvements of its suppliers.

They are not vulnerable to technological change. One need think of the impact on the laundry industry of the advent of dry cleaning.

They are not dependent on moveable assets that are people. When oneʼs key assets ride the elevator everyday, one has less control over oneʼs share of the added value chain.

Good companies are dynamic. They focus on the customer by knowing their clients ʼ desires and needs. For example, Keyence ʼs sales in industrial measuring devices are almost all custom solutions.

They are marketing oriented. LʼOréal spends in excess of 30 per cent of sales on publicity and promotions designed to differentiate its products.

They strive to improve quality. Essilor, the global leader in eye care lenses, dominates the performance segment of the market and is leading demand toward this area.

They manage change successfully. Luxottica is the world leader in eyeglass frames. It understood that retail chains are altering the market in a fundamental way. It acquired Lenscrafters (the leading chain), Sunglass Hut, and Pearle Vision to retain and increase its share of the value-added chain.

They practice financial responsibility. They maintain a strong balance sheet. Nestlé has a coveted AAA rating from debt rating agencies.

They refrain from aggressive accounting techniques.

They do not engage in inter-company financing as was the case of certain Japanese Kereitsu, Korean Chaebols, and Chinese or Italian conglomerates.

They enforce appropriate internal controls to avoid the fate of Barings, the British bank that was taken under due to a rogue trader.

They earn superior return on equity and assets, thereby generating returns from operations in excess of their cost of capital.

They balance short-and long-term objectives by demonstrating a willingness to endure the occasional short-term pain in exchange for achieving long-term gains.

Necessary Attributes

We believe the above list constitutes a solid description of the necessary attributes of great companies. Very few firms will meet most of the above criteria.

Now that we have highlighted the characteristics of what, in our opinion, constitutes a good company, letʼs attempt to identify the characteristics of a good stock. For this second part, I will rely on the work of noted professor Jeremy Siegel, through a review of his latest book, The Future for Investors.4

First, a definition – a good stock is one which beats the market over a sustained period of time.

Letʼs start Professor Siegelʼs book review with a provocative example: IBM versus EXXON. Which stock do you believe outperformed the other one according to the statistics in Exhibit 1?

Will you change your opinion if I add the clues in Exhibit 2?

Whichever way you answered, you could claim the right answer since IBM had a better price return, but EXXON clearly a better total return (See Exhibit 3). The explanation lies in the fact that stronger growth by IBM was more than already discounted by the price/earning ratio while the reinvestment of a greater dividend yield clearly favoured EXXON.

Conventional Wisdom

Siegel studied S&P 500 Index constituents from 1957 to 2003. His findings completely overturn most of the conventional wisdom that investors use to select stocks for their portfolios. His main initial conclusions are:

• On average, the more than 900 firms that have been added to the index since 1957 have underperformed the original firm in the index. Replacing older slower-growing firms with faster-growing names has lowered the return for the S&P 500.
• Long-term investors would have been better off had they acquired the original S&P 500 firms and never bought any new firms added to the index.
• Dividends matter a lot. Reinvesting dividends is the critical factor which gives the edge to most winning stocks in the long-term.
• The return on stocks depends not only on earnings growth, but on whether this earnings growth exceeds what investors expected. Portfolios consisting of the lowest P/E stocks outperformed the S&P.
• The long run of initial public offerings (IPOS) is dreadful, even if you are lucky enough to get the stock at the offering price.
• The growth trap holds for industry sectors and countries as the fastest ones have produced disappointing returns.

Remember, these are general conclusions and, therefore, one can always find exceptions. But when reviewing the methodology used in the study, these findings appear to be difficult to ignore. What do these results mean for specific stocks? Is the stock of a good company a good stock to own in a portfolio?

Best Performing Stocks

Table 1 shows the best performing stocks in the S&P 500 since 1957.

The following are Siegelʼs main conclusions to which I have added my personal comments. ◆ He says the best-performing firms for investors have been those with story brand names in the consumer staples and pharmaceuticals industry.

As Warren Buffett rightly claimed: “The products or services that have wide, sustainable moats around them are the ones that deliver rewards for investors” (See Table 2).

I would submit that low economic sensitivity (stable growth) and pricing power are key ingredients explaining the success of these firms.

• The basic principle of investor return, says Siegel, states that stockholder returns are driven by the difference between actual and expected earnings growth, and the impact of this difference is magnified by dividends.

In my opinion, growth in itself does not matter. The critical point is how much one pays for a dollar of growth. Moreover, if the cost of maintaining growth expectations for a company is high, pursuing growth will reduce returns versus returning the money back to shareholders.

• Siegel contends the majority of best performing firms have had slightly higher than average P/E ratios and average dividend yields, but much higher than average earnings growth. None had a P/E above 27. These are the characteristics of the corporate El Dorados.

This is highly consistent with our belief that superior businesses are great investments if purchased at reasonable prices. This is why we have never owned e-Bay even if it is one of the greatest franchises on earth.

• Portfolios invested in the lowest P/E stocks – in other words, those with modest expectations for growth – far outperformed those with higher valuations and expectations.

Essentially, this is right, but beware of the value trap as Professor Siegel combines valuation with expectation. Valuation alone is not enough. The firm has to deliver better results.

Also, be careful as there is always some survivorship bias at the low P/E end of the distribution. The firms with low P/E that have not succeeded are not in the index anymore.

• Professor Siegel says be ready to pay up for good stocks (as you would for good wine), but there is no such thing as a ʻbuy at any price.ʼ

To further the wine analogy, a litre of St- Estephe is clearly worth more than a litre of convenience store wine. So, why would a dollar in earnings be worth the same for every firm? Its worth is a function of volatility, future growth rate, duration of the growth rate… In essence, we should apply the same no-nonsense common sense to our stock investments that we use when making our daily life decisions.

Good Investment

Clearly, a good company does not always become a good investment. The price paid for the stock is very important as is the investment horizon. Acquiring the stock of a good company at a reasonable price will, in time, likely make a winner out of you. However, patience might be required from time to time as quality and price are not good timing tools per se. Success can only come from a clearly defined investment approach and the validity of this approach must have been proven. Knowing how to execute and understanding it takes time. To validate the results is also crucial. Buying superior businesses at reasonable prices is an investment approach backed by serious academic research.

Pascal Duquette is president and CIO of Natcan Investment Management.

1. PETERS, Tom et al. In Search of Excellence, New York, Warner Book Edition, 1982.

2. COLLINS, Jim. Good to Great: Why Some Companies Make the Leap ... and Others Donʼt, New York, Collins, 2001.

3. PORTER, Michael. Competitive Strategy: Techniques for Analyzing Industries and Competitors, New York, The Free Press, 1980.

4. SIEGEL, J. Jeremy. The Future for Investors, New York, Crown Business, 2005.

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