Why does quality matter in (value) investing?

[FrugalPatat]

Many (value) investing books suggest looking for quality companies at reasonable or cheap prices. But I don't understand why quality matters that much. I understand wanting a minimum level of quality because the business has to survive for the duration of the investment. But why is investing in high quality companies better than investing in average companies (that are undervalued)?

With quality I mean things like ROIC, good management etc.

[jacob]

Quality is just one out of several themes one could use. Graham famously focused on "cigar butt" companies that the market had priced below the value of its cash and saleable inventory and equipment if it were to be liquidated. That's certainly one kind of quality. For value investing all that matters is to buy when value < price and sell when price > value AND have a good method for calculating that value.

I suspect that the qualities you mention fall more under the "think like an owner"-school of investing. If there's also a preference for "never selling", it makes a lot of sense to only own quality of the kind you mention. Buffett famously broke with Graham in being willing to pay a little extra for that.

[zbigi]

I suspect that the qualities you mention fall more under the "think like an owner"-school of investing. If there's also a preference for "never selling", it makes a lot of sense to only own quality of the kind you mention. Buffett famously broke with Graham in being willing to pay a little extra for that.

He also said he ultimately regretted not selling Coca-Cola in the early 2000s, because he still somewhat adhered to holding "great companies" forever, regardless of stock price. The result was, KO-TR significantly underperforming SP500TR over the past 20 years.

[7Wannabe5]

I think the "cigar butt" concept also applies well to the mid-life dating market.

[candide]

[started typing this before anyone had replied. See "cigar butt" has already been mentioned... not trying to step on toes]

I think you nailed it with realizing that "quality" really means just enough quality to survive the duration of the investment.

The shorter duration you are planning to hold, the less that "quality" needs to be. But at some point, that means you're not investing, as much as trading.

When Buffett was a small investor, he described his early trades as finding "cigar butts" that have been discarded and getting the last puff out of them:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.

Here's an article about the dead-simple strategy Buffett's mentor Ben Graham used at the later part of his career, with sale rules of either 50% price increase or two years (thus the quality only needed to be enough to survive two years):
https://stingyinvestor.com/SI/articles/MS1005.shtml

But be warned that it's going to make your returns look wonky compared to everyone else:

I hasten to add that the Graham stocks didn't outperform each and every year. For instance, last year the Graham stocks gained 13% while the market climbed 18%. The Graham stocks lagged by 5 percentage points.

Unfortunately, poor relative performance is something that has to be expected from time to time. Indeed, despite its excellent long-term track record, the method trailed the market in eight of the last seventeen years and lost money twice.

If you are drawing down your money while you invest, this method exposes you extremely heightened (and idiosyncratic) sequence risk. And I don't think there is any framework for fully understanding why it is working or not. I speak from experience. You start saying "the market can stay irrational longer than you can stay solvent" ... and worse, here you are in the trenches with dogshit companies -- just not dogshit enough to be sold at this price, you say. (Conversely, it is fun when you own VNDA and it shoots up 50% in the course of two weeks, and you sell, and you see that while the stock still exists, but it is trading at half of what you paid in 2021... but then you realize that VNDA result alone may be why you bought a large basket of biotech stocks and got burned with it ... but can harvest those capital losses to re-balance your portfolio)...

If you're just interested in this space, another name to look at is Joel Greenblatt. I remember an interview where he tipped the hand that you can go full "value" only if you are willing to trade quickly, but he said that what he likes about factoring in quality (like ROIC), is that your margin of error increases over time — because the company is actually getting better. Quality buys you time.

[FrugalPatat]

what he likes about factoring in quality (like ROIC), is that your margin of error increases over time — because the company is actually getting better. Quality buys you time.

But the getting 'better' of the company can all be priced in, no?

[IlliniDave]

In my mind that's the whole premise of so-called value investing, "value" essentially meaning getting good quality at a favorable price. I suppose there are different ways do judge quality. Early on the idea of investing in stocks was to buy a share of a company's future earnings which would result in a strong and consistent dividend flow over time--so you would look for consistently profitable companies that were priced a little less than their peers. In time stock investing picked up much more of a buy low, sell high gamesmanship with the focus being to identify companies that you thought would grow a lot and provide large capital gains when stocks are sold in the future. For a while that led to some inefficiencies where a profitable company without a lot of room to grow might fall out of favor with "growth"-minded investors and be available cheap in terms of things like price-to-earnings ratio/dividend yield, etc. I'm not sure how much of that inefficiency remains as the overall market has been priced higher than it was during what I think of as the hay day of value investing for 30+ years now. But on some level, short-term traders/speculators aside, we're still buying shares in companies to gain a cut of their profits, present or future, less so in the form of dividends as they've fallen out of favor with the majority of investors.

[candide]

@FrugalPatat

Can, and usually is.

But value has its own problem, which is for it to pay off other people have to change their mind.

(And the more you think things are "priced in" the more you should just index).

[frommi]

You can value a company either based on its assets—essentially what it would be worth if liquidated—or based on its earnings or cash flow. When using earnings or cash flow, stable or growing figures are ideal, since they lead to a more consistent valuation; in this case, the market price may fluctuate, but the intrinsic value remains relatively steady. With an asset-based approach, the quality of the assets matters: cash is more valuable than receivables, which are better than inventory, which in turn are better than long-term assets, and so on. In both cases, I’d argue that quality ultimately comes down to stability.