Terry Smith on Quality Businesses

This proportion of your return from the companies’ reinvestment activities is even more extreme when you invest in a good company with a high return on retained capital than in an average company. All of this was much more succinctly encapsulated by Warren Buffett when he said: ‘It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.’ He made the transition from being a traditional value investor based upon studying under Benjamin Graham (author of “The Intelligent Investor” and “Security Analysis”) into a quality investor looking for companies which could compound in value based upon the teachings of Philip Fisher (author of Common Stocks and Uncommon Profits) and the influence of Charlie Munger. Here’s how Buffett explained this change in his 1989 letter to Berkshire Hathaway shareholders: ‘The original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces — never is there just one cockroach in the kitchen. [Plus], any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.investment

will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.’ The problems of waiting for value investment to pay off can be seen in the performance of the MSCI World Value Index (USD) which hit 6570 at the end of October 2007 and was lower than this at the end of February 2016. At 31st December 2019 it stood at 9812, just 49% higher than its 2007 peak value. Compare and contrast the S&P 500 (USD) which peaked on 9th October 2007 but had regained its 2007 high by 2013 and at 31st December 2019 stood 189% higher. Ah, but I can hear the siren song of the value investors who will take this data as confirmation that the resurgence of value investment which they have long predicted is about to commence. As an old saying goes ‘To a man with a hammer, everything looks like a nail’. The longer the strategy underperforms the market and the more money it costs investors the louder the siren song becomes. And sooner or later they will be right. But a) they have no idea when that will be (note the reference above to Investment Adviser’s comment in 2012); b) if you had followed their advice to date it would require a gargantuan reversal of performance to make up the gains forgone; and c) that may continue to be the case for some time to come.

The sort of stocks which trade on low enough valuations to attract value investors are unlikely to be those which we seek – businesses which can somewhat predictably produce a high return on capital employed, in cash, and can invest at least part of that cash back into the business to fund their growth and so compound in value. Unlike our strategy which is to seek such stocks and hold onto them, letting the returns which the company generates from this reinvestment produce good share price performance, value investing suffers from two handicaps. One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value. Moreover, it is a much more active strategy.this