Quality is king. That’s what Buffett and Munger have been preaching for a few decades and Berkshire is the shining example that it works.
Buffett has been laying out what to look for in quality businesses for a while now. I’ve been going over some his earlier thoughts on quality companies after listening to the BRK annual meeting.
Buffett’s lecture at the University of Florida probably is one of the best at describing examples of what he looks for:
I don’t want a business that’s easy for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and then I want the Duke, who is in charge of that castle, to be honest and hardworking and able. And then I want a big moat around the castle. And that moat can be various things.
That comes about through service. It comes about through quality of product. It comes about through cost. It comes about sometimes through patents. It comes about through real estate location. So that’s the business I’m looking for.
So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about – in a general way – where they’re going to be ten years from now. And if I can’t see where they’ll be ten years from now, I don’t want to buy it.
He’s since simplified it:
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
The problem with “quality” is that it’s elusive. Most quality companies trade at a premium. So that leaves investors to search for quality among the trash.
Yet, it’s not hard to imagine some investors could ignore price. Because that’s never happened before.
With the recent discussion on the 20th anniversary of Amazon’s IPO, the multi-year media promotion of the FANGs, and the “new normal” in higher profit margins, it’s hard not to notice some similarities to the past.
Some of the largest “quality” companies in the S&P 500 carry some of the highest PEs today. Alphabet (Google), Microsoft, Amazon, Facebook, Exxon, Visa, Coca-Cola, Merck, Starbucks, Netflix, and Salesforce all carry PEs above 30.
Investors seem to be willing to pay a much higher price for perceived quality (I’d argue it’s due to a warped idea that quality equals safety as investors still seek comfort from the financial crisis). Some of it is warranted, I’ll admit. But will the current trend turn into a buying frenzy? I don’t know.
Market history is filled with examples of investing ideologies taken to the extreme. In every instance, it was the ignorance of price that ended in eventual chaos.
The current chase for quality is reminiscent of the Nifty Fifty episode of the early ’70s. The Nifty Fifty were the darlings of the day. They were popular large caps at the time. They all had proven growth rates. They could do no wrong. The Fifty were lauded as the best buy and hold growth stocks for a lifetime.
Jeremy Siegel explains what the Fifty looked like at the ’72 market peak:
The Nifty Fifty did sell at hefty muliples. The average price-earnings ratio of the stocks was 41.9 in 1972, more than double that of the S&P 500’s 18.9, while their 1.1% dividend yield was less than half that of other large stocks. Over one-fifth of these firms sported price-earnings ratios in excess of 50, and Polaroid was selling at over 90 times earnings.
Eventually, that original message of “buy and hold” mutated and investors piled in as no price was too high.
Jeff Bezos, during a 2011 Wired interview, was asked about being one of the “four horsemen” of tech. His response was to ask an important question and offered his answer to it:
But one question to ask when you see a list like that is, who would have been on it 10 years ago? That will keep you humble. Go back to 1980. Who would you have predicted to be among the four horsemen of the personal computer era?
There are always shiny things. A company shouldn’t get addicted to being shiny, because shiny doesn’t last.
Investors shouldn’t get addicted either. Quality is the new glamour. Chasing glamour stocks rarely ends well.