Sunday, February 14, 2016
Cunningham et al., Quality Investing
Three characteristics indicate quality: “strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.” The investor’s challenge is to assess “the characteristics that combine to enable and sustain these appealing financial outputs.”
Through the use of extensive case studies of mostly European companies, the authors illustrate how to unearth patterns of quality. For example, good managers are essential. But “shareholders should be wary of any company whose chief executive is portrayed in the media as a business celebrity.” A study by two economists found that “award-winning CEOs subsequently under-perform both relative to their prior performance and relative to a sample of non-winning CEOs.”
The authors also point out the pitfalls of investing mechanically in companies that achieve solid cash generation, high returns on capital, and growth. Companies that seem attractive at first blush may simply be buoyed by “cyclical growth, the temporary tailwinds of fickle consumer trends, or technological leadership vulnerable to disruption.”
Quality investing cannot be reduced to numeric measures. This is one of its greatest challenges. As the authors write, “It is easier to explain that a stock is cheap than that a company is great.”
Quality investing is not a quest for the undiscovered. “In fact, many of the best companies are simple businesses that have done what they do consistently for decades. Worse, their quality is often, to some extent, already appreciated.” Successful investing “means accepting the relative dullness of analyzing what is often in plain view.”
Investors with a long-term perspective can profit in two ways from reading this book. First, they will enjoy the process since the book is clearly and engagingly written. Second, they will learn what has driven the success of some of the world’s top investors—and that they have the power to emulate this success. It’s not a simple formula and it involves work, but it is doable.