Buying quality at a reasonable price

By Morningstar |  24-12-19 | 
 

We are all familiar with Growth at a reasonable price (GARP). This investment strategy combines tenets of both growth and value investing by finding companies that show consistent earnings growth but don't sell at overly high valuations.

Not many are acquainted with Quality at a reasonable price (QARP). Neelesh Surana of Mirae Asset has made references to this. He claims that his investment philosophy is centred on participating in high quality businesses up to a reasonable price, and holding the same over an extended period. His focus is quality up to a reasonable price, which ensures that he avoids very expensive stocks or cheap stocks where quality of business/management is compromised.

Lex Hall, editor at Morningstar Australia, spoke to Ned Bell of Bell Asset Management very recently. They consider ourselves to be ‘quality at a reasonable price’ investors. Which means that they identify really good quality companies and look for opportunities to buy them well.

Here are some excerpts from that conversation.

I want to begin with a quote by Warren Buffett: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Is that what we are talking about when we talk about QARP?

Yeah, I think it is.

It's generating this distinction between the valuation risk that comes with quality investing and growth investing but also the earnings risk that comes with some of the growth investing we're seeing now. So, where we are now is, we're at a point where growth stocks have performed extremely well. But they're now the most expensive they've ever been. And value stocks have lagged considerably.

What distinguishes a company that you would consider fits the QARP criteria?

First, they have to get over a quality hurdle. So, when we think about quality, we're thinking about companies that have got great management teams, strong franchises, consistently high levels of profitability, strong balance sheets and good business drivers. So, they need to get over those hurdles first before they're even considered for QARP.

Then, at that point, you need to think about what you're willing to pay for it. So, typically, we tend to look at companies that are generating it, for example, return on capital in excess of 10%, 15% as a starting point, but then you don't want to be paying over the odds for those companies. So, you want to be typically paying less than, say, 25 times earnings for those types of companies. So, it's that balance between quality and value that's really important.

Explain with the example of, say, Tesla.

So, the first one, from a quality perspective, profitability is not generally synonymous with Tesla. So, it doesn't pass our quality test.

Again, it doesn't make that 15% return on capital threshold. And because it's not generating much profit, it's very difficult to value that company on an earnings level, because the earnings are always still to come, still to come, still to come.

The other issue with Tesla is because that's a very capital-intensive business, they're always rolling out new models, which means the profitability is always two years away.

What about Booking.com with regards to the QARP strategy.

Booking.com is a stock we've owned for a number of years. It is a leader in the online travel business. Most importantly, it's a really high return on capital, asset light business. They generate 25%+ return on capital. The stock trades on a P/E of about 17 times earnings and it's growing its earnings at 10% plus going forward.

So, the combination of those three things is really, really powerful because it means that we can make money through the P/E rerating, plus earnings compounding.

Home Depot.

Home Depot is one of the few brilliant U.S. retailers in what's been a very turbulent period for retail in the U.S. But Home Depot, Costco, maybe one or two others have been the real leaders. They've led that category for a number of years. I think, really interestingly, the reality is that the U.S. consumer is unbelievably strong right now. And so, as a play on the U.S. consumer in the tight labour market, I think Home Depot is a great way of playing that. And again, it's not that expensive. It's only trading at 20 times earnings. Again, 20%+ return on capital, will grow its earnings at least 10% going forward.

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