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Why It Pays to Pay Up For Good Assets
But what exactly are "good assets" anyway?
One of the many pieces of wisdom I got from Jim in our interview a few weeks ago was the concept of buying the leader in each sector. In fact, it was one of his ground rules, although he has since relaxed it a bit.
I asked Jim to weigh in a little more on this concept, and here’s what he had to say.
I like to buy the leader in each sector because even though it almost always looks expensive, the long-term returns are there. I also think that helps me hold, since I know I’m sitting on the best choice. In sectors with lots of competition or a duopoly situation, I’ll buy what I view are the two leaders.
Your author, meanwhile, has embraced a slightly different approach. I guarded the security of my dividend income fiercely, taking various steps to ensure it would go up over time — including diversifying heavily, and taking multiple positions inside the same sector.
Basically, I took a look at the most important variable to my early retirement — the income — and made sure I didn’t screw it up. I wanted to build a portfolio that would survive a 2020 or a 2008-09-type event, where previously healthy companies cut their dividends in droves.
I had also worked really hard to get to the point where I was financially independent, and having a diverse portfolio is one of the ways I chose to protect that. The problem, of course, is the line between having a diverse portfolio and a overly diverse one can be pretty thin. They have a word for that — diworsification.
Unfortunately, investing isn’t simple. One can tell an investor to buy quality all day long, but without a few more details the advice isn’t really actionable. Indeed, the investment world is littered with the corpses of former darlings, high-flying “quality” stocks that turned into the exact opposite.
Where you fish also matters. You could’ve bought the highest quality marijuana stock during the boom of 2018, for instance, only to watch that investment go up in smoke. Pun totally intended. There isn’t much difference between being down 97% and being down 100%.
So let’s take a closer look at quality this Sunday
morning afternoon, focusing on how you can identify it, how it pays off, and how it’s often a pretty complex exercise.
How to identify quality
Just how exactly does one identify a quality company, anyway?
Unfortunately, much of the discussion for quality really comes down to one thing — long-term performance. If a stock has done well over the long-term, the argument says, then it is a quality company.
There’s a reason why such analysis is so commonplace today, even if it is super lazy. Companies that have outsized performance over time tend to keep doing well. I definitely give a company that has done well over time bonus points when I start to do my research.
But here’s the problem with the whole price argument. One of the most important lessons I’ve learned in the past few years is price drives narrative. A company that is doing well is automatically added to the quality basket, even if the underlying results might not warrant such an inclusion.
Another similarly lazy piece of analysis centers around dividend growth. If a company can hike its dividend consistently for a number of years, the refrain goes, then chances are it’s onto something.
Both methods of analysis are basic, but they continue to be used because they work.
There are also many companies very quietly performing behind the scenes that, for whatever reason, don’t get credit for what they’re doing. A great example is Stella Jones, whose share price was essentially flat from June 2015 to October 2022. Yet the company’s underlying metrics were doing just fine:
Revenue almost doubled from 2015 to 2022
Operating income was up 65%
Earnings per share increased from $1.50 to $3.93
Shares outstanding decreased from 69M to 61M
More info can be found in this post I did for paid subscribers a few months ago.
Eventually, Stella Jones rewarded patient shareholders, and the stock has rocketed higher in 2023. Most everyone agrees the company is high quality these days, pointing out its near monopoly position in the sectors where it operates, the high barriers to entry, and the steadily rising dividend. But I’d argue the company was really high quality the whole time, and the price just didn’t reflect it.
There are also investors out there who will say that no matter what a company does behind the scenes none of it matters if the price doesn’t cooperate. They can allocate capital effectively, repurchase shares, and grow the bottom line, but at the end of the day none of that matters if the share price doesn’t cooperate.
This analyst disagrees, and continues to think companies doing the right things will eventually be rewarded. In fact, I think those situations are fertile hunting grounds for new investments.
In short, a company is typically put into the quality basket if it:
Grows revenue and earnings per share over time
Pays an ever-increasing dividend
If the price goes up
You’ll notice I put the price going up last. As the Stella Jones example illustrates, a price can do nothing for years as the underlying business improves.
Identifying quality — Canadian banking
Another way investors identify quality is to look at the underlying financial results and compare them to peers.
Here’s how this works. An investor will identify certain financial ratios they deem to be important, and then compare companies in the same sector using these metrics. If one outperforms pretty consistently, it’s then regarded as being high quality.
National Bank of Canada is a great example here. National Bank has outperformed each of its peers over the last 10-20 years. This, in turn, has made the company a popular choice, although with only a minority of investors. Most either avoid banking altogether (it’s a black box, see?), or they’re content to choose from the Big Five and ignore National.
So I took a closer look, and what I found is that for years now, National has delivered better growth than its peers — mostly due to its smaller size — and has posted higher returns on equity (ROE) than its larger peers. Return on equity is what a lot of bank investors look at, so they buy the stock with the highest ROE.
Seems pretty simple, right?
I dug a little deeper, and basically National Bank’s high ROE is due to a couple of different factors. Firstly, it hasn’t really diversified into the U.S. like its peers. U.S. banking is a lower ROE business than Canadian banking because of the increased competition. Instead, National diversified into banks in places like Cambodia, where there’s less competition and higher ROEs.
Now that we have an explanation for National’s outperformance, we can make an educated guess at whether this ROE outperformance will continue. I think it will, so I have National Bank in my portfolio.
Sometimes, the quality argument is pretty simple. Other times, it’s not so simple. Instead of identifying certain attributes that make an investment high quality, investors will chalk it up to qualitative factors. The management is good, for instance. Or they have a good company culture. These types of qualities are very hard to identify, and are often used as a justification to help explain why a stock has done so well — after the fact.
How quality pays off
Let’s look at the life insurance sector to see just how much owning a quality name versus a non-quality name might pay off.
Despite many investors — including your author — owning Manulife shares, the company really hasn’t done that well over the last decade. Including reinvested dividends, it has grown by about 7% per year from 2013 through today.
Sunlife, meanwhile, is up more than 10% per year in the same time period. That extra 3% worth of return really adds up over a decade.
Sunlife is viewed as the higher quality option because:
It has similar Asian growth as Manulife, but without the dependence on China for that growth
It has a better balance sheet than Manulife
It didn’t cut its dividend during the financial crisis of 2008-09, and Manulife did
But! Manulife also has some things going for it, including:
Higher earnings growth over the last decade than Sunlife (96% versus 70%)
Better dividend growth since 2015 (118% versus 102%)
Much cheaper on a price-to-book value and price-to-earnings perspective
A better dividend yield today (6.1% versus 4.7%)
Sunlife outperformed Manulife by a pretty wide margin despite all the things Manulife has going for it. That’s the power of quality.
The bottom line
When it comes to identifying quality, we can take the simple approach or we can take the complex one.
The simple approach is to look at a company’s total return over the long-term, and sprinkle in a little dividend growth as confirmation. Since dividend growth tends to go hand-in-hand with earnings growth, we can assume a company with a growing dividend also has earnings growth.
Or we can make it more complicated and look at a million variables, hoping to find a laggard that somehow turns the corner and becomes known as a quality investment. This can certainly happen, and laggards in many sectors can become good investments, but generally simple quality wins out.
I also think it’s a lot more difficult to identify quality in a falling market. In a world where most every dividend stock is down because of higher interest rate fears, it can look like the whole sector is trash. After all, isn’t the big identifier price? This is when it pays to dig a little deeper.
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This week’s upcoming posts are on Franco Nevada and Granite REIT.