Balancing Quality Against Valuation In Equity Analysis

Balancing Quality Against Valuation by David Merkel, CFA of The Aleph Blog

A letter from a reader:

Hi David,

I am XXX, from India. I started reading your blog since few months. Few of the things i learnt, and much more are really complex for me to understand, the learning is ON.

Somehow i decided that ” being good value investor and control the behaviour” is a gift of long practice and learning. So it takes time and for me the learning is still in lower phase. I am in middle of understanding Financial statements.

But before that i want to invest and enjoy the power of compounding. Till now i used Mutual Fund, Fixed Deposit (bank) for my wealth creation. As part of my milestone, i want to go ahead with shares for my Kids education and retirement.

I like to Buy Consumer staples like Nestle India Limited (BOM:500790), Gillette India Limited (NSE:GILLETTE), GlaxoSmithKline Pharmaceuticals Limited (NSE:GLAXO) which are past compounders. Given a India’s Economic growth and Population growth, I foresee these socks can do well. But it is already at very high PE (Nestle – 42, GSk consumer- 39, GSK pharma – 52, Gillette -141). I don’t foresee any panic selling on these stocks. What i will do? how i do buy Quality business with good valuation?

Kindly guide.

thanks for sharing such wonderful posts.

Dear Friend,

You have described the optimal situation: buy businesses that have well-protected boundaries, and buy them cheap.  I wish I could do that.  Everyone would like to do that.

But that is where judgment comes in.  I would rather own cyclical businesses with competent and honest management  teams, than own high growth businesses at very high multiples of earnings.  I would also rather own slow growth businesses at modest multiples of earnings.  Ask yourself: where am I getting a reliable stream of earnings and growth relative to what I am paying for the stock?

In general, with growth stocks, never pay more than 2 times the earnings growth rate  for the P/E of the company.

Often you have to look at companies that are neglected, and I would like to recommend a book to you: Investing in India.  The author avoids highly valued companies in India, and aims to invest in companies that are fair to outside minority, passive shareholders.

Look at more stocks than just the highest quality stocks, and look at the valuation tradeoff between highest quality stocks, and lower quality stocks.  Most value investors accept the lower quality stocks, if their ability to produce value relative to their price is better than that of higher quality stocks.

All that said, part of the question is how long will the high quality stocks have a significant advantage.  In the US, on average, that advantage has not been long.  Maybe things are different in India, but maybe not.  Be careful.  Remember, the cardinal virtue of value investing is having  a margin of safety, not cheapness.