R.B. (Biff) Matthews is chairman of Longview Asset Management Ltd.
Warren Buffett’s recent annual letter to shareholders reveals that, over the past five years, the increase in Berkshire Hathaway Inc.'s book value was less than the investment return provided by the S&P 500 index. This has rekindled a long-standing debate between two schools of value investors.
Members of the “deep value” school typically invest at a price far below a normal multiple of the company’s earnings or net asset value, with the expectation that the multiple will revert to a long term average within a couple of years.
In contrast, “high quality” value investors such as Mr. Buffett focus less on finding a company that is statistically inexpensive, and more on identifying highly profitable companies with a durable competitive advantage. The goal is to buy these companies at a sensible price and own them for the long run.
In the real world, value investors fall somewhere on a spectrum, with deep value at one end and high quality at the other. So the real question is – where should you focus your attention?
Deep-value investing has been proven to work. Numerous independent studies have shown that if you buy, at the beginning of each year, only the cheapest 10 per cent of available public companies – measured by a low price to earnings (P/E) ratio, or a low price to book value (P/B) ratio, and sell them at the end of each year – and repeat the process for 10 years – your return will far exceed the stock market average for that period. In Canada, investors who have followed a deep value approach for the past 20 years include Prem Watsa of Fairfax Financial and Irwin Michael of ABC Funds – both highly successful investors with enviable track records.
There is no equivalent, objective proof that buying high-quality companies and holding them for the long run results in outperformance. In part, this is because the definition of a high-quality company is somewhat subjective. Even if we could agree on a few measurable quality factors, and wanted to run an objective test to see if these factors resulted in higher returns, how often would we change the portfolio? Every year, every five years, or every 10 years? It is difficult to objectively test the efficacy of high-quality investing over the long run.
And yet we know that Mr. Buffett and other investors who focus on owning consistently profitable companies with steady growth in earnings and a reasonably predictable long-term future – companies such as Nestlé, Coca-Cola and Johnson & Johnson – have far outperformed the market averages for decades.
Why have these investors succeeded? As is so often the case in investing, it’s all about the hidden benefit of time. Time is the friend of the wonderful business and the enemy of the mediocre.
Some companies, including a number of global consumer staples businesses, operate predictable businesses with a durable competitive advantage and a long runway. If a company has had consistently high profitability over the long run and has an identifiable competitive advantage, there is a good likelihood that this will continue. This allows the company to reinvest its profits to earn more profits. Stability of growth in earnings adds to both the compounding effect and the predictability of future growth.
These quality factors are not determinative over 12 months, but, over the long run, they make a huge difference.
For taxable investors, buy-and-hold investing has an additional advantage. No capital gains tax is payable prior to the sale of the shares, so the compounding of value takes place on a before-tax basis. Over time, this adds greatly to your wealth.
So, where should an investor focus – deep value or high quality? For most people, owning high-quality businesses for the long run is the best route to outstanding investment returns. As Warren Buffett said in an earlier letter to shareholders, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”