Forget Growth vs. Value – Stick to Quality

There has always been a debate on growth versus value stocks. Both of these broad classes of stocks have taken turns to outdo each other over various periods of time.

Why not focus on quality instead of trying to time growth versus value?

Quality stocks have strong balance sheets, high returns of invested capital, and most of them have the ability to raise prices. These quality companies tend to outperform the markets over time.

Investors like to chase growth stocks for their exciting growth, but not all types of growth add shareholder value. Some companies destroy shareholder value as they grow.

We recently read a book by Peter Seilern, in his book “Only the best will do”. Here are some thoughts comparing two industries:

 

Airlines

In the old days, flying was an experience in itself. Airlines primarily catered to business travelers.  The rise of low cost carriers allowed many more travelers to fly with significantly lower prices of air fares. This has enabled millions to travel the world. The tagline “everyone can fly” has resulted in a huge capacity increase and intense price competition.

Hurray for consumers like me.

But sometimes, the headline growth story may not gel with creating shareholder value.

Even before COVID-19, the return of invested capital for the airlines industry has been below the cost of capital. The International Air Transport Association (IATA) engaged Mckinsey to conduct an industry value chain analysis. The following chart comes from their 2020 report:

In short, every incremental dollar deployed in the business doesn’t cover the cost of that dollar. Here, growth destroys shareholder value. In fact, airlines generate value for the supply chain and less so for themselves (refer to the chart below).

Many technological changes have happened in the airline industry: engine efficiency has improved in the last 20–30 years, and online check-in and bookings have saved costs. The problem is that most of the tech advancements are available to all airlines. Due to intense competition, the savings or surplus accrues to the customers now filling the seats.

Cosmetics

Estée Lauder is the leading producer of cosmetics and beauty products. It has been a beneficiary of social and demographic trends. Their ROIC has been about 20%. This is substantially above their cost of capital, creating shareholder value. Moreover, they have the ability to raise prices over time and grow organically.

Peter Seilern, in his book Only the Best Will Do, highlighted other examples of such value creation quality growth companies, including Mastercard, Dassault, and Fanuc. The key similarities of these quality companies include the following:

1) High ROIC and the ability to reinvest at high rates of return — For every $1 invested in the business, you get a high return (maybe 20–30 cents per year) over extended periods of time. These quality companies have the ability to reinvest at high rates of return to compound capital for all shareholders.

2) Strong, organic growth that can sustain more than 10 years over various economic cycles — To sustain this growth, the companies do not need to invest a huge amount.

Putting both the high ROIC and growth together, we can see how it shareholder value over time. Let’s look at the example.

Here, we see a comparison between company A that grows its retained earnings at 11% a year versus company B that only compounds at 2% a year. The results are a whopping 284% versus 17% increase in retained value for shareholders.

3) Sustainable competitive advantage or what we term as a moat or a barrier of entry — Refer to our upcoming article on Moats.

4) Strong financial position — Quality companies do not need to rely on the “charity” of banks to grow. Too much debt can always be a problem in an industry downturn.

Quality companies can raise production volume with minimal capital expenditure so that the cost burden can be minimized. They also can raise prices to offset costs over time.

During periods of higher inflation, instead of worrying about timing the market with value versus growth stocks, investing in quality companies would be a better idea.

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