I was reading Warren Buffett’s most recent letter to Berkshire Hathaway’s shareholders, always looking for a small nugget of wisdom. This may be foolish to consider but I don’t always agree with what he says. For example, he mentioned that one of the things he looks for in deploying new capital is companies with “able and honest managers.”
It’s not like I have an issue with able and honest managers but at my level of investing, I don’t personally know the board of directors or executives any public company. I’m a long-term investor and I’m sure eventually somebody or somebodies will come along and do poorly. Just look at what happened to GE at the helm of Jeffrey Immelt.
Anyway, two very important things he looks for when deploying new capital is quality companies at value prices. At the surface, this makes sense and is very logical. But when you consider this at a deeper level I started to think about Yin and Yang.
Yin and Yang
Yin and Yang is an ancient Chinese philosophy about dualism, describing how seemingly opposite or contrary forces may actually be complementary. Quality and value can be considered opposite from each other. Shouldn’t quality stocks be given a premium price?
When I think of quality, I don’t think of something being priced low or being undervalued. It’s contradictory thinking that you can buy a Tiffany’s bracelet at 20-40% off what they are normally priced. But in the world of the stock market, these things happen.
Exxon Mobil is dealing with the coronavirus and slower global growth in addition to climate change headlines. Johnson & Johnson is has their hands full with asbestos concerns in their talcum powder. 3M is dealing with cancer-linked chemicals in their non-stick products.
These are quality “Tiffany” type of companies dealing with headlines and other types of concerns. Quality companies overcome these concerns just like they have over the past 50 or 100+ years. Lawsuits, war, headlines, and new trends and innovations are constant issues dealt with by companies. But quality companies overcome these issues decade after decade. Where many business might fail, they survive and can actually thrive.
If you follow this blog, you know I’m focused on building a portfolio of quality companies at sensible prices. This philosophy is actually quite simple but it takes discipline, patience, and diligence with your approach. The focus of this article will explore my focus on quality and how to buy these companies at sensible prices.
Quality Over Quantity
I was having coffee with my wife this morning and we were discussing the definition of a quality company. For sure, it’s a heavy duty topic that needed sufficient caffeine to kick-in before we had the discussion.
Though the list isn’t all inclusive, we quickly rattled off a list of items within minutes. These are things that quickly came to our minds and found themselves in two categories:
- Subjective – Familiar iconic name brands; products that are desired by society (i.e. candy, soap, bleach, tampons, coffee, airplanes, band-aids, and alcohol); best in breed; ability to adapt
- Objective – Consistent revenue, cashflow, and earnings; reasonable debt structure; decades of continued (no cuts) and rising dividend payments; ability to raise prices; company longevity; sector / industry leader; usually larger market capitalization; less price volatility compared to the overall market
Quality can be defined in many different ways and everyone’s list can be different. Everyone needs to define quality and what’s important to them in a quality company. The list above is something two late-50’s people quickly described over coffee.
I guess one might say you know quality when you see it. Like when a product is so widely used and important to society that even generic products are named after it. Johnson & Johnson’s Band-Aids represent a generic term for adhesive bandages is a great example.
Create Your List
You’ll want to create a list of all companies that are potential lifetime holdings in your portfolio. When you have a list put together, it’ll probably look like the usual suspects. Names that we’ve all heard of before so there likely won’t be any surprises.
In your browser, search “most valuable brands.” Look at the dividend aristocrats or dividend kings list for companies that have paid dividends for more than 25 or 50 consecutive years. This data should give you a good place to start building your list.
A product that is widely used doesn’t mean it’s owned by a quality company. But it’s great to look for quality brands with iconic products. Look in your pantry, go to the mall, or go to the store and the names will be everywhere.
I’d suspect you’ve created a list of 50-100 names. From there, start looking more deeply into the companies objectively. Red flags might be high debt loads, lots of stock price volatility, or decreasing revenues. Keep working on your list … constantly add and delete names as your further your research.
Eventually, you’ll create significant Watch List just like the one I’m creating that will continue to evolve. It will be from that list that your buy companies for your portfolio. Companies that you’ll likely buy and never sell. Remember, these companies have been through several wars, recessions, and severe headline concerns and continue to pay dividends and grow revenue and earnings.
Don’t every stop editing your list. Get ideas from this blog and many others. Use stock screeners and keep your eyes open for opportunities you’ve never considered. And what do you do with this enormous list you’ve created? You identify the price your are willing to pay for each of the companies. You want quality companies at sensible prices.
Value – Never Pay Full Or Premium Prices
When searching for value, it will likely come at you in one of two ways. First, you’ll find individual companies that are dealing with headline, revenue, or litigation issues that temporarily push their stocks down. If you’ve already built your list of quality companies, it’s easy to see when one of those companies has a bad week, month, or quarter.
Usually, a stock is on sale for a reason. Maybe they had a poor earnings report or something bad made the headline news. But sometimes you can find a company where investors are in complete disagreement with the assumptions, fundamentals, or future of the company. It happens more often than you think and it’s the folks with available cash that take advantages of those circumstances.
When an industry leader – Exxon Mobil, Johnson & Johnson, 3M – suddenly hits the news with an oil spill, product recall, or major lawsuit, the stock price will get hammered. Many people just can’t stomach seeing even the strongest of companies price go down and they panic. When this happens, investors are making decisions to both sell and buy.
The other way you’ll likely find value is when it comes at you like a tsunami or all at once. We are seeing this today with the coronavirus concerns. This virus, and the potential impact it could have worldwide, has pushed even the highest quality stocks down 20% or more. The stock market had it’s fastest drop into correction territory (at least 10%) in market history this past week.
Think about that for a moment. Quickest drop of more than 10% EVER. That’s why you need to be ready with your list of quality names and have some cash available to take advantage of the drop. Market corrects and great opportunities can come at you quickly. And, of course, you can’t panic sell. It’s times like these when real money is made.
The thing to remember about sudden drops in the market is that quality stocks will be the first to recover when the selling stops. That’s why it’s so important to own quality names because the selling will eventually stop.
Change Your Mindset
One of the many great things my wife taught our daughters was how to buy products on sale. She taught them about the value of their dollars when buying clothes, shoes, toilet paper, and many other everyday items. And when buying stocks, many of the same concepts apply.
You ever wonder why someone is willing to buy Coca-Cola after a 10% decline on bad sales or sudden stock market drop when you are trying to sell? I’m going to ask you to completely change how you think about stock prices going down. It will feel unusual and maybe even make you sick to your stomach at first. But when a quality stock goes down in price by 5-10%, I want you to get excited even if you already own the stock.
“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
Warren Buffett
In the above quote, Warren Buffett is saying be greedy when others are fearful. When Coca-Cola is down 10% after a bad earnings report, it’s an excellent time to buy. Quality companies are usually fairly consistent with their earnings so you know it’s likely a temporary issue and not some long-term systemic problem.
When stocks are flat for several years, especially after a swift run-up in price, all that means is the stock is catching it’s breathe while the earnings match the price or investor expectations. And when that happens it’s time to buy again.
Just a couple of weeks ago, I wrote an article about Finding Value. In it, I list 10 names that are closest to my desired price. Now that the market is moving down really fast, I’m shrinking that list to just a few names that I’ll add to my portfolio. I’m also rethinking the price I’m willing to pay too. When conditions change you have to rethink your plan.
This is no joke! As I sit here and write this article, a friend texts me stating they’ve move all of their 401(k) funds to cash. This is a person that is 10 years away from retirement and they move to cash AFTER a 15% drop in the market. And now they ask for my advice? This is panic selling at it’s finest and this is the mindset that needs change.
Summary
Quality and value might not sound like to concepts that belong together but when they do it’s special. In most cases, quality companies come with a premium price but paying premium (or retail for shoppers) is for suckers. Screen for quality and value to avoid buying junk.
It’s the patient investor with a plan that wins. Identify quality companies, know what price you are willing to pay, and be patient. Have some cash on hand for those rare moments when everything comes on sale during a sudden market drop.
And for goodness sakes DO NOT panic sell. Quality stocks will be the first stocks to recover. Sudden market drops bring premium-priced high quality stocks potential buying opportunities. Market drops are gifts to those with a plan, cash, and patience. Be one of those people.
FINAL NOTE: I highly recommend reading Warren Buffett’s annual letters (1976-2019) to shareholders, even the older ones. If you can gain just one item out of each letter you will have achieved a masters degree in investing.
Thanks for reading!
Mr. TLR