A retail investor mistake to avoid

This article will cover a topic that I think is very timely in the current market environment: overpaying for a stock because of the business’ “quality.”

Usually, these are the stocks of businesses that produce goods and services that are household names, or they manufacture products like consumer staples or necessities like electricity and water. Because of the steady demand for these products and services, investors feel they will have reliable and consistent returns, even during recessions. Big-name brands, dividend streaks and steady earnings, along with some basic business quality metrics, seem to be the factors investors lean on most to describe “quality.”

That, in and of itself, isn’t necessarily a big problem. But what is a problem is that investors tend to then go one step further and assume these sorts of factors that contribute to a “quality” designation for the business also justify a higher valuation for the stock. In short, investors are willing to pay more for quality. Often a lot more. And when they do, they are making a big mistake that will nearly always produce poor returns.

Defining ‘quality’

In order to understand my approach to “quality,” it’s best to start with the simpler example of bonds, and then apply what we learn there to stocks. If you buy a bond and hold it until maturity, your nominal return will be whatever the bond yield was when you purchased it. As I write this, the U.S. 10-year Treasury bond yield is +3.76%. So, if you buy one of these bonds and hold it for 10 years, then you will earn 3.76% per year on your investment, provided the U.S. government pays its obligation. In this case, the quality of the bond is determined by two things. First is the odds that the U.S. government will pay you, and the second is the inflation or deflation rate during the holding period. If we assume there is no inflation, and the U.S. government pays up, then this is a quality investment. If the borrower who is issuing the bond does not pay their obligation, then it would not be a quality investment. In my opinion, at least in retrospect, we can very clearly define what was a quality bond investment (one in which you were paid back what you were owed) and a non-quality bond investment (one in which you were not paid back what you were owed). If we take this basic understanding and include inflation so that if you are paid back your money with interest and that amount is greater than inflation, then you made a “quality” investment, and if you are paid back an amount with interest that is lower than the rate of inflation, it was a “non-quality” investment, we have a pretty clear understanding of a quality vs. a non-quality bond investment. And while we can always come up with more complicated examples, I have found this basic, binary definition of quality to be very useful in stock investing.

Many decades ago, Warren Buffett introduced the idea of treating stock investments as equity bonds. That understanding has inspired much of my core “full-cycle” investing approach. The simplest way to treat a stock as an equity bond is to take a stock’s earnings yield (which is the inverted price-to-earnings [P/E] ratio, or E/P). So, a stock with a 20 P/E ratio would have a 5% earnings yield. Then, treat that earnings yield just as you would a bond yield. The one caveat is that some businesses can be expected to grow their earnings over time, so rather than just collecting that earnings yield, the investor also gets the benefit of any growth of those earnings over time. This is one of the major benefits of holding stocks long-term rather than bonds (and why I don’t own long-term bonds). If there is inflation over the given time period, a bondholder loses purchasing power, while a good business can pass on inflation to its customers, allowing earnings to grow at a rate equal to or higher than the inflation rate. So, for a “quality” business, inflation is not a serious risk to the purchasing power of the earnings because the business can pass on higher costs, and its earnings rise accordingly.

My definition of quality is that the business has earnings that have a history of growing at a rate above average long-term inflation, which is roughly 3% or so in the United States. In addition, in order to be high quality, the business must have experienced a recessionary environment, and earnings must have recovered from the recession in a timely manner. In addition to these factors, I make sure there aren’t any clear signs that the historical earnings pattern will change any time soon. Basically, if I can count on earnings per share, adjusted for buybacks and recession downturns, to grow at a mid single-digits rate or better, then I am dealing with a “high quality” business. How fast earnings are growing beyond that is irrelevant when it comes to determining quality. A business growing earnings at 5% and a business growing earnings at 15% are the same quality as far as I’m concerned, all else being roughly equal.

What this definition does is strip any brand-name bias or dividend-streak bias, or fluctuation of earnings, out of the equation (as long as they are not very deeply cyclical and recover in a timely manner from downturns). A utility or consumer staple business doesn’t get any extra quality points from me if they grow earnings at 6% every year without exception compared with a business that has more volatile earnings but still grows cumulative earnings over a full economic cycle. They are both high quality to me. Similarly, I don’t give brand names any special treatment compared to a company whose brand I’ve never heard of, either. If the earnings metrics are there and look like they will continue, they are both high-enough quality.

So, first I look to see that the historical data is there to determine how earnings have grown in the past, then I check to make sure there isn’t some clear impediment to earnings growing similarly in the future and that the rate of earnings growth is higher than inflation. If there is reason to expect these things are true, the business is high quality enough to evaluate for a potential purchase.

What this quality designation boils down to is that quality businesses can 1) pass on inflation to their customers, and 2) reliably grow earnings at least a little faster than that over a full economic cycle. It’s very simple.

The truth is, if we take a 5-year or 10-year time period, it’s relatively easy to identify high-quality stocks in the market today. Probably 400 out of the 500 stocks in the S&P 500 are high quality, and a decent investor could do a reasonably good job of predicting the earnings trends 5 years from now. The difficulty is maximizing one’s returns. Getting low single-digit returns over 10 years in the stock market is pretty easy in almost any environment. You could throw darts at a list of S&P 500 stocks and achieve that. But if you want to consistently do better than that, valuation is what is important once basic quality is established, and it’s buying at attractive valuations that will help an investor achieve better-than-average returns over the long term.