Great businesses produce great returns. As Warren Buffet said “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Rather than heading the great mans advice, most investors underestimate business quality which results in unduly low market valuations for the very best companies. As an individual investor, understanding quality and its true value can lead you to craft an investment strategy that exploits market inefficiencies.
What Makes an Extraordinary Business
So what makes a business extraordinary that deserves a premium rating? A truly great business can come in many guises but by and large there is a need for an enduring enterprise that is earning extraordinary returns for extraordinary periods of time. The sustainability element is critical as it implies the business news to have some sort of competitive advantage or economic moat. The competitive advantage allows the business to protect its above average returns from the unrelenting assault of its competitors.
Apart form generating sustained above average returns, another less talked about advantage of sustainable business models is that it is easier to predict cashews far into the future due to the being defensible and more repeatable. The importance of being able to predict future cash-flows cannot be underestimated as it helps in calculating intrinsic value. (For businesses that produce lumpy or cyclical cash-flows, it is far harder to calculate intrinsic value and this leads to many an individual investor overpaying for shares in cyclical businesses).
Whilst describing an extraordinary business is simple and straightforward enough, finding such examples in the real world is a much harder thing to do. Examples of companies with sustainable and high returning business models are Unilever due to its strongly branded consumer products, Microsoft due to its networking effects and Visa due to its unique position of being the financial plumbing of the payment industry.
Whilst most of the initial research into what makes a great business is qualitative, there are a few quantitative methods investors can use. The best tool for checking the reliance and sustainability of a business is to look at the company’s long-term Return on Equity (ROE).
To understand the concept of Return on Equity, have a look at the following example. Suppose Company A has a long-term ROE of 11% and currently trades at a PE of 19x. If this ROE does indeed hold for the next 20 years, then assuming 100% of Company A earnings are reinvested at this same rate the total equity of Company A will also grow at a rate of 11% per annum; in line with its ROE. If the PE ratio remains at 19x at the end of the 20 year period, the share price will likewise have appreciated at a rate of 11% per annum. Obviously this is a simplistic example to help you understand the concept of ROE – in the real world, not all earnings are reinvested at the same rates of return and P/E ratios tend to fluctuate over time. The important point from this example is that an investor should expect returns in line with ROE over the long-term, provided the valuation of the firm does not change. Essentially, higher ROE businesses provide higher Annual Returns.
It should come as no surprise then that superior businesses should trade at premium valuations as compared to the general market. After all, it is these companies in which the market has the most faith when looking into the future. For example, it is easy to extrapolate that the best branded consumer goods companies – such as Unilever – will still be earning decent returns from their products 20 years from now just as they have for the previous 20. It is harder to be as confident about many of the other, lower quality concerns that populate the index which frankly may not even exist two decades from now. In practice we express this confidence in one of two ways; by using a lower equity risk premium in our DCFs (we will go as low as zero for the very best businesses) or through the application of a higher valuation multiple to a company’s earnings. In contrast, research has shown that most investors fail to recognise the importance of a sustainable competitive advantage, unfairly penalise high quality, repeatable earnings with excessive risk premiums and low multiples.
(The equity risk premium is the extra return you hope to generate on top of the ‘risk-free’ rate, which in the UK is benchmarked against the UK 10-year government bond. At the time of writing, the 10-year gilt yield is 1.31%. The equity risk premium is the excess return required by shareholders to justify investing in stocks rather than risk-free government bonds. The FTSE All-Share index has achieved 6.35% total return so far this year. Deducting the 1.31% risk-free rate means the equity risk premium, or the reward for investing in equities, is approximately 5%)
When looking at valuation levels of the very best businesses , it is very telling that market participants are failing to differentiate between levels of quality in this way. There is this long running argument that high quality business can support the higher valuations placed on them without giving up much return.
Professor Jeremy Siegel, in his book the The Nifty-Fifty Revisited showed retrospectively that a high quality, well-branded company such as Coca-Cola, with a steady earnings growth record could in fact support extremely high multiples – even higher than Coke’s then PE of 46x. A year or two after the Nifty Fifty stocks had hit their peak valuations this multiple was criticised as having been a severe overvaluation, perhaps with some justification for those with shorter term time horizons. However subsequent price gains demonstrated the opposite as long term holders of Coke’s shares, despite some poor performance from 1972-1985, actually compounded returns at 17.2% per annum total return over the 25 years from 1972-1997. Siegel showed that for Coke to have performed no better than in line with the market between 1972 and 1997 it could in fact have started on a PE of 92x It just goes to show that paying up for growth could prove to be great value!
Unilever – The Great Business Warren Buffet Wanted
Unilever is an excellent company. There is no doubt about that. The company has a 40% ROE for the past 20 years and has increased its dividend by 8% compounded over the last 50 years! The excellent fundamentals and its deep entrenchment of emerging markets are reasons why Kraft Heinz made a takeover approach earlier this year which Unillever correctly rebuffed.
When looking at Unilever’s valuation before the attempted takeover when it was trading around the £31 mark, I thought it was slightly above fair value. And I was not alone in this. For at least the past 3 or 4 years, there has been scepticism about the valuation of Unilever and similar ‘bond proxy’ consumer staple companies. This scepticism intensified following the late 2016/early 2017 sell-off in government bonds and rally in commodities. There was persistent chatter that the time of quality growth was over and people should tilt their portfolios towards ‘cyclical value’. However, and contrary to this expectation, one must note that the two biggest shareholders of the Kraft Heinz company, namely Warren buffet, who knows more about valuation than most and 3G, arguably the most successful private equity concern of the past decade, placed a £40 sighting shot on Unilever’s equity. That’s 30% more to where Unilever was trading at and 20% above Unilever’s average price over the last year. Furthermore, this is pretty much double the price it was 5 years ago.
This just shows how special companies like Unilever are very rare and very valuable. Warren Buffett in a recent interview described the US long bond as “an entity on 40x earnings with no growth”. In comparison, Unilever valued more like 20x earnings and growing at 5-6% per annum looks a real bargain. So the question is, how much are you willing to pay for quality companies in this return-free risk world?