Quality could still be underpriced by markets

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By John Authers

Credit Suisse research suggests Warren Buffett is right

Form is temporary. Class is permanent. The sportswriter’s cliché also applies to companies. There has long been an argument that some companies truly are better than others and will outperform through good times and bad.

Warren Buffett, in particular, has lent his name to the idea. On this logic, he bought companies such as Coca-Cola and Gillette even though they were not very cheap. He said an excellent company at a decent price made a better buy than a fair company at an excellent price.

While this makes sense, it raises questions. How exactly do you measure quality? And can good performance really be expected to persist, without reverting to the mean?

New research by Credit Suisse suggests that Mr Buffett may indeed be right about this. Strong companies tend to stay strong while poor ones are mighty difficult to turn round. This has nothing to do with “shareholder-friendly” policies and everything to do with managing a company ruthlessly to maintain its cash flows and profits.

The researchers measured value creation with their own metric that they call CFROI, for cash flow return on investment.

It is based on cash flows (not earnings, on which accounting manipulations are possible and which are affected by leverage), adjusted for inflation, as a proportion of operating assets – a measure that excludes accounting devices such as depreciation allowances.

By taking inflation and different accounting rules out of the equation, the metric allows comparisons across time, countries and industries. It produces some fascinating findings.

Overall, looking at the returns companies make for all their investors on this measure, the average over the past 60 years is 6 per cent but the dispersion is startling.

Over that time, about a quarter of companies have managed 11 per cent or better while another quarter have managed 3 per cent or less.

That makes it all the more significant that strong companies tend to stay that way, as do weak companies.

Globally, more than half the companies in the best 25 per cent as measured by cash flow return on investment are still in the top 25 per cent five years later. The same is true for those in the bottom 25 per cent.

Most tellingly, only 9 per cent of companies in the top quarter descend to the bottom quarter, while only 6 per cent of the worst quarter ever make it back to the top quarter.

This suggests that mergers and acquisitions, or aggressive turnround strategies under new managers, have little effect. If a company’s economics are sound, it keeps making good returns; if not, it is overwhelmingly difficult to make it a truly attractive investment proposition.

There are positive reasons for this, such as a strong corporate culture. Companies with a clear mission and sense of how to achieve it will endure more than those that lack such things. And managers who inherit them should not be overpaid.

Other drivers of repeated outperformance have to do with competition or the lack of it. Mr. Buffett’s quest for companies with a “wide economic moat” is a euphemism for companies with an entrenched anti-competitive position.

If you have few competitors and barriers to entry are high, it is no surprise that your performance stays good.

Comparing industries, household and personal products showed up with the highest persistence of performance. The sector also generated the strongest absolute returns, an average of 13 per cent since 1985.

Even if products such as soap or soda should be cheap and easy to replicate, global branded companies have built formidable barriers to deter new entrants.

The sectors where companies are most likely to revert to the mean over time include insurance, semiconductors and real estate. In general, financial groups, and energy and materials companies, all show less sticky performance over time; it is harder to pick a winner in these sectors.

Materials groups showed up as value-destroyers with an average return since 1985 of only 4.8 per cent. Makers of toothpaste exert great control over the prices they receive; miners of metals do not.

Is there money to be made from this? Investors tend to notice when a company produces strong and persistent returns and bid up its shares. But Credit Suisse’s work suggests that persistent quality is still a little underpriced in the stock market – suggesting that investors underestimate the chance that strong performance will persist.

The top 20 per cent of companies as measured by cash flow returns made 10.9 per cent per year, against 9.1 per cent for the universe as a whole – and 4.5 per cent for the weakest 20 per cent. Buying only those persistently strong companies that are cheaper than the market improves these returns further.

So this is an interesting way to make money. Spend time identifying companies with a strong, persistent competitive advantage and hold them and you are unlikely to be sorry. It works for Mr. Buffett.

© THE FINANCIAL TIMES LTD 2013 FT and ‘Financial Times’ are trademarks of The Financial Times Ltd.


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