What would you do if I handed you a map to the Holy Grail of investing? Would you toss it in the trash because Nobel Laureate economists say it’s impossible to beat the market with less risk? Or would you give it a thorough read to see if there is any validity? Let’s find out.
So, how exactly can you earn better investment returns with less risk? In a word: Quality. Yes, it’s that simple. By focusing your investments in high quality (wonderful) businesses you can earn better returns with less risk.
What is a High Quality (Wonderful) Business?
Companies that consistently grow their earnings regardless of the underlying business atmosphere are “High Quality.” These wonderful companies tend to be the cream of the crop in their industry, with key competitive advantages that allow them to continually prosper over the long run. These businesses come in all shapes and sizes, although they typically exhibit three key characteristics.
1) Maintain outstanding financial strength.
2) Possess a unique business model.
3) Are run by top notch people.
As you can see, these are both quantitative and qualitative characteristics that high quality companies possess, making it difficult to judge quality. Just as beauty is in the eye of the beholder, Quality is in the eye of the astute investor.
Fortunately, the financial service firm Standard and Poor’s (S&P) has published quality rankings over many years. This provides a simple method for measuring quality. These rankings are based on the company’s most recent 10 years of earnings and dividend data and range from A+ (highest) through D (Lowest). The better the growth and stability of earnings and dividends, the higher the ranking.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett Berkshire Hathaway 1989 Annual Report
High Quality = Better Returns
So why does one of the greatest investors of all time focus on buying wonderful companies at a fair price? The major reason is high quality stocks generate better returns over the long run. In a long term S&P study, over the 30 year time span between 1981-2011, High Quality Stocks (S&P Ranks B+ or Better) earned average annual returns of 14.9% significantly outperforming its Low Quality counterparts (B or lower) at 8.7%.
Why Do High Quality Stocks Outperform in the Long Run?
It’s easy to forget that buying stocks is actually becoming an owner in a company (you get much more than a volatile ticker symbol). Over the long run your investment’s performance will ultimately be determined by the company’s business results. Since high quality businesses by definition are those with steady and superior earnings growth, it makes perfect sense that their stocks generate superior returns in the long run over their low quality counterparts.
To put the High Quality vs. Low Quality results in dollar terms, if you invested $100,000 in low quality stocks in 1981 it would have grown to just over $1.2 million by 2011. That is nothing to sneeze at. However, by comparison, a $100,000 investment in high quality stocks would have grown to $6.4 million – over 5 times the low quality amount! That is a remarkable $5.2 million dollar difference over 30 years.
Given the superior performance of high quality investments that we just discussed, you might find it fascinating that they actually are less risky to boot. That’s right, better returns with less risk, the ultimate investment combination. Who said you can’t have your investment cake and eat it too!
High Quality = Less Risk
ValueLine, founded in 1931, is a highly regarded independent investment research firm that ranks companies by “Safety” ratings. Their rating system compares and combines a company’s balance sheet, financial strength and price stability to arrive at a safety rating (similar to the S&P Quality Rankings). I used the ValueLine safety rank data during the last 16 major stock market declines from 1972 – 2016 to calculate and compare high quality vs. low quality performance during major market downturns. As shown in the table below, high quality stocks go down much less (-14.6% on average vs. low quality stocks -31.0%) during significant stock market declines.
To put the comparison of High Quality vs. Low Quality during a typical correction in dollar terms, if you had a $1,000,000 investment portfolio in low quality stocks at the beginning of an average correction, it would have shrunk to $690,000 7-months later. However, by comparison, a $1,000,000 investment in high quality stocks would have dropped to $854,000 – a much less painful decline! Most importantly, going down less in a bear market also means it is much easier and faster to recover from the decline and ultimately reach new recovery highs. By focusing your investments in stocks of the highest quality, you not only can increase your returns and you get added drawdown protection when it’s needed most.
Why do high quality stocks better protect your portfolio during major market declines?
To answer this question it’s important to understand when major market declines are most likely to occur. Typically the worst market declines occur when the economy enters a recession. In fact, over the last century, 3 out of every 4 bear markets for stocks (-20% or greater declines) have occurred during recessions.
By definition, a recession is a shrinking business environment: sales and profits decline in aggregate. As companies lay off employees to cut costs, the unemployment rate rises and household income decline, creating a grueling economy. This is precisely when high quality businesses thrive. Typically, these companies continue making money while their competitors struggle to stay profitable. Their outstanding financial strength and steady profits provide added flexibility to go on the offensive when their weaker competitors are doing all they can to simply stay in business.
In the midst of a recession led bear market, investors crave the added security of high quality investments and are reluctant to discard wonderful companies when economic uncertainty reigns supreme. In other words, high quality stocks tend to be owned by long-term oriented investors who much prefer to add to their investments when the going gets tough, while other short term oriented investors may sell into weakness. This helps to keep high quality stocks from undergoing dramatic and sustained downturns, providing an additional layer of protection to your hard earned money.
Better Returns + Less Risk = Added Peace of Mind
So, there you have it! High quality is the roadmap to the Holy Grail of investing (better returns with less risk). By focusing your investments in stocks of the highest quality you not only can increase your returns and lower your risk, but you can also sleep better at night. Efficient market hypothesis proponents believe it’s impossible to achieve better returns with less risk, so they recommend to buy everything (index) and follow your “random walk” down Wall Street; however, numerous studies, including financial research from Standard & Poor’s and ValueLine, confirm that the quest for better returns with less risk is attainable. There is no doubt that over our financial advisory firm’s 40-year history, one of the most crucial factors that help our sub-advisory clients sleep better at night is the fact that their hard earned money is primarily invested in high quality businesses.
Disclaimer: Pring Turner is a Financial Advisor headquartered in Walnut Creek CA, and is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. The views represented herein are Pring Turner’s own and all information is obtained from sources believed to be accurate and reliable. This information should not be considered a solicitation or offer to provide any service in any jurisdiction where it would be unlawful to do so. All indices are unmanaged and are not available for direct investment. Past performance does not guarantee future results.
© Pring Turner Capital Group
© Pring Turner Capital Group
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