The Power Of Quality Businesses
This is a great description of the power of quality.

Source: Saber Capital

What this figure shows is:

  • You can buy a business at more expensive prices and earn higher returns.
  • Great companies earn high returns on retained earnings.
  • If companies can reinvest earnings at high rates, their best allocation decision will be to keep pumping it back into the company and avoid dividends.
  • Even if the company gets a lower exit multiple, the earnings power gives you your margin of safety.

When I posted this on Twitter, a few people mentioned that quality companies don't trade for cheap. Here are some names in my portfolio that say otherwise:

$INMD 37.88% ROIC. PE 15.
$QFIN 51.54% ROIC. PE 2.6

I don't mess with companies that have one off high ROIC numbers which drastically regress to the mean. While I admit the numbers above will slightly subside over time, they are taken during pretty poor economic conditions. If you hunt for quality that is well priced, you will find stocks that other investors are afraid to own.
Conor Mac's avatar
I remember reading this one actually, was a great piece.

I feel like the debate between paying up for quality vs buying potential value traps will always be ongoing. The risks come when investors pay up for what they believe is quality (when its not) and grabbing a cheap stock which they think is a bargain (but its a value trap). Money can be made paying up for genuine quality, as well as buying great companies down that suffer temporal mispricings to the downside.
The Thinking Investor's avatar
Thanks Conor. Money can definitely be made in multiple ways (paying up for quality or buying cheaper lower quality businesses). This is just what is suiting me personally.

I agree that value traps are an ongoing concern. Any investor looking to invest must be vigilant in being able to identify quality and constantly update their thesis to ensure the investment is actually maintaining its high quality status. I think a lot of investors accidentally mistake short term tailwinds for maintainable quality. When the tailwind is ends the market will justifiably change the price. The fact it’s not high quality becomes easier to identify. There have been many examples of this due to COVID.