Dimensions of Quality Investing
Growth and value are dimensions of quality. Growth and quality are inputs of value. Value and quality are components of growth. These are not mutually exclusive investment philosophies but frameworks each choosing a different emphasis to tell signal apart from noise.
All agree that a business’s value is its expected future cash flows discounted at the appropriate rate. Value looks to the durability of existing cash flows, while growth looks to the promise of potential cash flows. Quality is fond of durable growth with high returns. But none disregard the other philosophies entirely.
Investment consultants like boxes. Which box are you in? Which box is this stock in? The Morningstar Style Box implies quadrants are mutually exclusive and collectively exhaustive. While such tools can be useful for clients, they should not constrain our thinking lest we become caricatures of our style. Value can’t be reduced to buying stocks on a low near-term multiple, nor can growth be defined as “not that,” i.e., buying high-PE stocks. Quality isn’t a soft middle between growth and value.
It’s therefore worth pondering what a nuanced understanding of quality investing might look like. The dictionary defines quality as “the degree of excellence of something.” That’s a good start. Quality investing seeks companies that exhibit a high degree of excellence. If you tell yourself “What a great business,” chances are you’re looking at a quality company.
Quality to me has many dimensions. Any binary where one end is more desirable than the other is a dimension of quality. High or low gross margins, which would you rather have? A wide or narrow moat? Growing or shrinking revenues?
Of course, dimensions will often trade off against each other in practice. High growth may suppress margins. But that doesn’t challenge the notion that the ideal business would have both growth and high margins.
Growth investing trades off low near-term multiples for high future growth, while value investing does the opposite. But both would prefer a growing business on a low multiple. Quality overtly recognizes that both value and growth are desirable traits in a wider constellation of attributes.
Taken together, the ideal business looks a lot like the legendary griffin. It has the back half of a lion and the front half of an eagle. It has the growth and dynamism of a growth company with the dependability and low multiple of a value company. It also doesn’t exit. No business will ever score perfectly across all dimensions of quality. How could a business have a long operating history in a stable industry and grow fast? But that’s not the point. Quality is the investment philosophy that recognizes all the ways companies exhibit excellence.
Warren Buffett similarly described his mythical ideal business when he said:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite — that is, consistently employ ever-greater amounts of capital at very low rates of return.”
His ideal price for such a business would naturally be as low as possible. Wouldn’t we all — growth, quality, and value investors — want to find a business trading for very little, capable of reinvesting enormous quantities of capital at astonishingly high rates?
It behooves all investors to identify the dimensions of quality that matter most to them. What trade-offs are you most comfortable with? Are you willing to trade profitability for growth? Would you rather settle for slower revenue growth if it meant more durability of current earnings? Some dimensions might also be clear disqualifiers. You may choose to exclude all companies earning less than a mid-teens return on capital from your investable universe or run by a professional management team. Think of the exercise as another way of sharpening the contours of your circle of competence.
Sacha Meyers.