Why sell great businesses for the mediocre?
Bob Desmond, Claremont Global
Within the last 12 months the market narrative has switched from fears of deflation to concerns of inflation.
This narrative is often coupled with the forecast that "value" is likely to outperform "growth". In this article, I discuss why, rather than focusing on economic predictions, or market themes such as value or growth, we prefer to focus our efforts on a concentrated portfolio of 10-15 high quality companies whose earnings are likely to be materially higher in 5-10 years and whose current price should allow the fund to meet its long-term return objectives of returning 8-12 per cent per annum (p.a) ― regardless of what economic outcome prevails.
Let's start with the inflation/deflation question.
Those arguing that inflation is on the way like to point to the following factors - a rapidly growing money supply, artificially low interest rates, growing budget deficits, wage pressures and rising commodity prices. It makes for a pretty convincing argument.
However, when I talk to the deflationists, they like to point to ageing demographics, record debt levels and the ever-present deflationary forces coming from technology. They also note that after the global financial crisis (GFC) the same narrative that quantitative easing (QE) and high commodity prices would lead to inflation, has so far been wrong.
Those arguing for inflation will point to the Austrian economists and the experience of the 1970s, while the deflationists will point to Japan and more recently the period following the GFC.
To be honest, I find both camps make reasonable arguments. This is why, when asked by clients, my answer is quite simply "I don't know". Experience over many years has taught me that things the "experts" tell us are "obvious", often don't come to pass.
Below I list some "obvious" events that never came to be.
One. In the late 1980s it was "obvious" Japan would come to dominate the global economy, just before they entered a 30-year period of relative economic decline.
Two. The stock market crash of 1987 that would usher in what some people thought was a new "Great Depression". In reality, share indices were up in that year and the economy did not experience a recession for another three years.
Three. The GFC that would lead to a new "Great Depression" and a lost decade. In reality, the US achieved record low unemployment of 3.5 per cent in 2019 and the stock market is up over six times from its 2008 lows.
Four. The exit of Greece from the Eurozone and the impending collapse of the Euro in 2012.
Five. The collapse in oil prices by over 60 per cent in 2014, when "experts", including the Federal Reserve, said oil would remain above $100 per barrel indefinitely.
Six. Less than one third of the "expert" pollsters actually predicted Brexit.
Seven. Only two major polls predicted that Trump would win the US Presidential Election in 2016 and ― even if you got that forecast right ― who then predicted that the market would rise by 14 per cent p.a. during his Presidency? As an aside, I also remember the narrative ― very similar to now ― that Trump would spend large amounts on infrastructure and reduce the market dominance enjoyed by the large technology companies. This actually provided a very nice buying opportunity for large cap technology.
Eight. In 2008 I did not see one single economic forecast that suggested in 2021 we would have negative yielding bonds, double-digit budget deficits and people talking about modern monetary theory (MMT).
Nine. The "experts" at the Treasury who forecast that COVID-19 would see the Australian economy shrink by 20 per cent, only to see output at a new record high in Q1.
The legendary Ben Graham was not one for economic or market forecasts:
Like Ben Graham, our investment process is totally devoid of any economic or market forecasts. You will not see our daily investment meetings start with an analysis of the latest musings from the Federal Reserve or the latest production numbers from China. It is not to say we don't read newspapers and have our own personal views, but we deliberately exclude projections about the economy, markets, themes or sector "bets".
Focus on quality companies
We control our overall risk through the quality of our portfolio companies. Rather than forecasting economics or markets, we simply prefer to focus on earnings power, balance sheet strength and sustainable competitive advantage.
To look forward, we always start by looking backwards, and our first point-of-call is to analyse how our businesses have fared in tough times - the GFC usually provides an excellent case study. Not one of our companies got into any form of financial difficulty, was forced to cut its dividend, or raise emergency capital.
Over the last decade, the average earnings growth of the companies in the portfolio has been 12 per cent p.a. and across the portfolio, the weighted debt/EBITDA is 0.5x.
As to sustainable competitive advantage, the operating margin across our portfolio is 25 per cent ― nearly two times the average US-listed business, and the average age of companies in the portfolio is over 80 years, with the oldest dating back to 1866. This does suggest some form of sustainable competitive advantage and resilience!
As a result, this financial resilience and earnings power allows us to be confident that our companies are well placed to weather the inevitable adverse economic events when they occur. Knowing this, we are free to spend our time looking for companies with long-term sustainable competitive advantage and earnings power, rather than trying to forecast how economies and markets will affect the short-term cyclical prospects of what we own.
Growth versus value
And as for all the talk about buying traditional, beaten down "value" stocks? For argument's sake, let's assume the "experts" crystal ball is in good order ― should we switch from "growth to value"? What does this actually mean in practice?
Well, first of all, we would be forced to sell a portfolio of competitively advantaged businesses (and pay a lot of tax and brokerage) to put together a portfolio that had exposure to banks, oils and other more cyclical businesses. This collection of businesses would have lower margins, higher balance sheet leverage and reduced long-term earnings power.
An alphabetical perspective
To take it one step further, let's assume you owned all of Alphabet (the parent company of Google) - would you really be happy to sell a business currently growing revenue at over 20 per cent, with over 90 per cent market share, a rapidly growing Cloud business and net cash of $120 billion?
Would you really be happy to buy a collection of European banks, where instead of net cash, your equity is leveraged 10+ times; you have limited visibility of the loan or derivatives books and decreasing confidence in times of stress; your profits are at the whim of Central Bank interest rate policy experiments; and where capital allocation is also determined by the same regulatory authorities, bearing in mind banks were required to suspend dividend payments by the European Central Bank during the COVID-19 pandemic.
Alternatively, would you really be happy to sell your dominant search engine monopoly to buy an oil business, whose profits are determined by a volatile commodity price input ― and in the long-term may potentially become extinct owing to new technology or inadequate reserve replacement. Any rational business owner would tell you this makes no sense at all!
Carrying on with the Google example. The company listed in 2004 at $85 a share and has since delivered a return of 22 per cent p.a. Over that period the Fed has met 136 times, which provides plenty of fodder for the economic and market prognosticators. How many of those "experts" predicted the GFC, the Euro crisis, Brexit, Trump becoming US President, COVID-19, negative yielding bonds, MMT etc?
It did not require a huge leap of faith to see the Google search business was clearly superior to any alternative, with an increasing economic moat, driven by an incredible network effect, informational advantages and capital resources to hire the best talent and maintain its technological dominance.
A long-term investor (as opposed to short-term speculator) would have generated a more predictable and healthier return by just buying what was clearly a great business and doing nothing. But no Doctor ever really achieved fame and fortune by recommending two aspirin and an early night!
In summary, we believe what makes sense as a business owner, makes sense as an investor. We try not to forecast hard-to-predict events ― and even more importantly we don't sell great companies that we know intimately, to buy mediocre ones based on economic or market forecasts that are quite likely to be wrong.
As Warren Buffett so aptly puts it:
Funds operated by this manager: