Balancing Quality Against Valuation In Equity Analysis

reminiscences of a stock operator pdf

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.

Sincerely,

David



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.