'Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount'.
- Charlie Munger
‘Quality’ investors such as Munger, Fisher, or Terry Smith say there is almost no price too high to pay for high quality businesses. But how much can you really pay? And surely valuation must matter to your total return? If I buy a ‘poor’ company at a low enough valuation, could I not earn a similar return as purchasing a really expensive great company?
Before we run the math, I look at the total investment return as two major components: FCF yield + growth. The FCF yield is the FCF divided by the market cap at the time of purchase and represents the ‘valuation’ piece of the return. The growth in FCF is a function of the return on capital and the reinvestment rate. In short:
Investment return = ( FCF / market cap) + ( ROE * reinvestment rate )
So how much can you really pay for a high quality business?
Let’s assume two debt-free companies: company A earns 10% on equity and company B earns 20% and both reinvest all cash flow for 20 years. If you buy and sell B at book value, you will earn the ROE = 20%. You earn exactly what the business generates on capital because the FCF yield or ‘multiple’ you pay is unchanged.
If you pay 23x book for B, which is the equivalent of 115x earnings, and sell at 24x earnings, you will still earn 10% over 20 years. So you will likely match or outperform the market IF you find a company that can compound capital for 20 years at 20% EVEN if you pay 115x earnings book and sell at 24x.
If you extend the holding period to 40 years, you will earn 15% per year. You can pay 650x earnings today for company B and sell at 24x (the company is still high quality with a runway) after 40 years and earn 10% return. This is the power of compounding. Your returns look like this:
So 100% of your returns are in the final 20 years of a 40 year holding period. These returns are driven by the future FCF growth of the business. This future growth in FCF has to be non-consensus OR the stock by definition would be priced in a way that would compound at the discount rate i.e. no excess returns. Quality investors tend to miss this point: it's not just the case of buying 'quality' at any price, the growth can't be discounted in the current price.
If you purchase company B at 100x earnings and sell at a market rate of 18x, you earn 14% per year for 40 years. BUT if the company only grows 20% for 20 years, your return is 9% and you would be -1% per year for 10 years. So even if you buy a company at 100x that grows 20% per year for 10 years, you’re underwater. Over 100% of your returns of a 20 year period, would be in the last 10 years of holding the stock.
Terry Smith may say you can buy L'Oreal for 281x earnings BUT you need to hold it for over 20 years to get in the money. So, not only do you need to choose a company that can consistently earn excess returns, but you need to have a non-consensus and correct view on future growth AND hold it for long enough to enjoy the returns!
Let's take a more realistic example today of Microsoft. It trades at about 33x NTM earnings. If you buy MSFT today and sell at the market terminal multiple of 18x, you can see the return profile below if MSFT compounds at 10% or 20%:
The key point to highlight here is that IF you forecast the growth rate incorrectly, and MSFT only grows at 10%, you only earn 1.82% after 10 years. This gets to the crucial power of compounding in that the longer the holding period, the more time you have for book value to compound and reinvested earnings to drive returns.
The most important variables for quality investors are ROE and reinvestment runway. This drives future FCF growth for the business. ROE and the potential to reinvest the cash flow is purely down to qualitative factors: how strong is the company's competitive positioning that will enable it to sustain long-term excess returns?
If we go back to the return calculation:
Investment return = ( FCF / market cap) + ( ROE * reinvestment rate )
If you only hold a stock for 1 year, you don’t have time for the company to benefit from reinvestment of earnings. So the shorter the time period, the more valuation matters.
Let’s assume Company C has 5% ROE and reinvests all earnings. If you buy C at 25% of book value and can sell at book, your returns for Company C and A at the respective ROE are:
If you hold company C for 20 years and sell at book value, you will earn 12.43% per year. Remember, if you just bought and sold a 5% ROE company at the same valuation multiple, you earn 5%. So 60% of the 20 year return is purely down to valuation. Graham-esque net-net investing falls into this bucket where you may purchase relatively poor companies but pay such a cheap price that you can earn good returns when the company re-rates to trade at or above book value.
There are clear differences in the driver of returns for low and high quality companies. High growth, expensive companies are driven by future FCF growth which compounds book value and low ROE growth is driven somewhat equally by valuation expansion and cash flow or dividend income.
In short, there are many ways to skin a cat. Both types of investing work: ‘Graham-esque net-nets’ and Fisher / Smith / Munger quality investing. The former relies more so on buying at a large discount to NAV and flipping as quickly as possible, the latter on choosing and holding the great companies that consistently beat expectations year after year.