What is wrong with “Quality at any price” argument?

Jaykumar Kakkad, CFA
Nov 7 · 3 min read

“Excessive confidence in smooth seas can blind us to the risk of storms” — John Bogle

by Espen Bierud

Driven by poor performance of value stocks & Cyclical in the last decade, the investment philosophy — “Quality at any price” argument has got stronger. The main argument is that if the horizon is long enough (10+ years), a quality business will produce market beating returns even if PE ratios are significantly higher (even 50x+) in India. Examples like Asian paints, HUL, etc are often quoted on such arguments. I too like quality businesses but I believe they may not necessarily be good investments. Hence, I am not a fan of ‘quality at any price’ argument.

What happened to the quality basket in 70s? ‘Nifty fifty bubble’ in US during 60’s and 70’s offer interesting insights. Nifty fifty was a group of stocks identified by the market participants. These stocks shared similar characteristics — high quality franchise, strong balance sheets and steady profitability. Driven by strong returns, this group of stocks traded at very high valuations by early 1970s. During the recession of 1973–74, these stocks came under severe selling pressure. Xerox (-71%), Polaroid (-91%) and Avon (-86%) are examples of severe de-rating during that period. For the next decade, this basket of stock under-performed the S&P 500.

However, there is another side to this story. A paper by Prof Siegel in 1998 (Link) points out that if one were to invest in equal weighted portfolio of these stocks even at its peak in 1972, they would have matched S&P 500 returns by 1998. Also, some of the stocks like Walmart, Macdonalds did provide 15–20% over two decades. So buying these high PE but quality stocks may not have been a bad decision in hindsight. Just that the portfolio would have under performed for two decades (See chart below).

Source: AAII article by Jeremy Siegel in Oct 1998

Takeaways & Conclusion: High PE may not necessarily mean over valuation as the earnings growth over decades can still create value. However, if such a company disappoints the downside is severe. I believe human ability to predict evolution of businesses & various risks over a decade is limited. Hence, when you buy a high PE stock it could either turnout to be a Walmart or Polaroid. Even for the most intelligent investor, there is an element of luck involved. To account for probability of a mistake, one needs to keep ‘margin of safety’ when buying a stock and hence even quality needs to be bought at reasonable valuations. Warren Buffett summaries this well -

‘On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment — if not permanently, at least for a painfully long period’ — Warren Buffett

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