Quality should always come with a premium.
When investing the “quality” tag for a company implies that it possesses or is exposed to superior investment characteristics and has measurable competitive advantages. Further quality can be viewed through either a relative or absolute lens and we have previously pointed to the observable outperformance of quality stocks versus the market over medium or longer term time frames.
At Clime, we broadly consider the following characteristics as identifiers of quality:

  • High and recurrent return on equity
  • Self-funded from operating cash flows
  • Sensible apportioning of earnings to dividends and reinvestment
  • Less cyclical or secular growth
  • Competent, ethical and shareholder-friendly management
  • Moderate or no gearing


How much does the market actually pay for quality and what is the premium that quality entails?

The answer to this question cannot be answered in a static way and should not be contemplated with short term analysis. Prices are constantly moving with speculators adjusting market prices based on changing sentiment, analysis, monetary conditions and anything else that creates price volatility.
The essence of value leading to price and driven by quality can only be seen and analysed over longer time frames. True equity investment that captures the compounding returns of quality companies is not a speculative endeavour. It requires discipline and patience.
Therefore to understand the relationship between price and quality we will review the market performance of a number companies within sectors to draw some conclusions in market price behaviour.

Banks:

The banking sector in Australia is tiered in a clear hierarchy which makes it a useful sector to commence the exercise. There are majors and regionals. However, even in the major category there has been a dispersement of quality.
When looking at banks, a number of factors contributes to the quality premium in the market, including:

  • Higher and more historically sustainable return on equity (a function of NIMs)
  • Risk of loan book (diversity of geographies, quality of borrowers, diversity of industries)
  • Access to cheaper and larger amounts of capital in local and international markets
  • Wider geographical footprint

In terms of ranking the quality of the banks, it is generally accepted that the majors are of a superior quality than the regional banks. Within the majors, Commonwealth Bank remains the premier stock, followed by Westpac and finally ANZ and NAB who are in a constant jostle for number three and four.
Whilst some of the other major banks have had periods of higher NIMs than Commonwealth in recent years, none have remained as consistent nor as appealing on a risk-adjusted basis. This would account for how the banks generate their interest income, either through lending to riskier or secure borrowers.
As can be seen from the below charts, CBA has generally been priced by the market at the highest P/E of the majors, and even more consistently, ANZ has been priced at the lowest. What is more interesting, however, is the relative difference in P/E’s over time. By comparing the 3-month average rolling P/E’s of CBA and ANZ, we can see the varying degree of premium that the market has attributed to CBA since 2007. What can be said is that even after giving back 2 P/E of its premium over ANZ, CBA is still trading at a historically expensive premium to its peer competitor.
1 Year Forward Implied P/E’s Major 4 Banks
Figure 1. 1 Year Forward Implied P/E’s Major 4 Banks
Source. Thomson Reuters Datastream
Figure 2. Rolling 3 Month P/E premium CBA/ANZ
Figure 2. Rolling 3 Month P/E premium CBA/ANZ
Source. Thomson Reuters Datastream

Infrastructure:

Infrastructure companies manage their capital and distributions in mostly similar ways across the sector. For instance they are seen to distribute 100% or more of reported profits and they are generally heavily financially leveraged. This leads to the observation that these companies are highly correlated to bond yields and interest rates.
Factors that would denote quality in this sector include:

  • Foresight on future reoccurring revenue streams
  • Cash-flow generation
  • Access to and cost of capital
  • Lack of competitive pressures (monopolistic market position)

The chart below, plotting SYD, MQA and AZJ’s dividend yields over time, tells an interesting story.
Infrastructure assets are priced on their long-term ability to generate sustainable and growing income, yet the significant variation in yields do occur over time suggesting that the market is not always efficient in the short term.  For instance SYD has moved from yielding a 4% premium to AZJ to AZJ yielding almost a 1.5% premium to SYD. Whilst MQA and SYD have seen yield compression on the back of interest rate cuts by the RBA, AZJ has seen its implied yield increase, suggesting a significant negative rerating of the business by the market.
Looking at the changes over time in SYD and AZJ, we can see very different price stories have unfolded. These movements were driven by underlying thematics that each of the businesses were exposed to. For SYD, a falling $AUD and the rapidly rising middle-class in China meant inbound tourism growth rates have boomed, resulting in a significant boost to revenues for SYD. The market has been extremely comfortable in rerating the P/E of the stock higher and compressing its yield as rates continued to fall.
Meanwhile AZJ has been negatively affected by the same thematics. A rising $AUD and falling commodity prices has made Australian coal  miners less profitable in international markets, threatening the volumes that AZJ moves across its lines. The continuing rise of China’s middle class has meant a significant push from its government to gear growth away from capital investment to consumer spending. Contrary to SYD, this has seen the market demand a higher yield over time as future earnings become less certain.
On stock specific factors, MQA has moved from an inverse relationship with rates to being somewhat correlated. What has changed here was significant returns of capital to investors as well as the removal of non-core assets, resulting in a higher average asset quality and a perceived increase in the future consistency of earnings.
The interesting point about the pricing of quality in the infrastructure sector is that the market generally takes the prevailing economic conditions and assumes them into perpetuity. This goes against the cyclical nature of many markets, especially ones exposed to currencies and commodities. The contrarian investor would point out that buying an expensive cyclical asset after years of positive tailwinds is a risky proposition, and likewise might point out buying an asset which has experienced significant ongoing headwinds over a multi-year period could be a good idea – assuming the market is pricing perpetual capital off bottom of the cycle metrics.
Figure 3. Dividend Yields SYD, MQA and AZJ + RBA Target Cash Rate
Figure 3. Dividend Yields SYD, MQA and AZJ + RBA Target Cash Rate
Source. Thomson Reuters Datastream

Resources:

Being in a highly cyclical sector, resource companies are by nature not of high quality. The sector is notorious for being a capital sink and has provided little returns to investors over longer time frames. Like the bank sector, the resource sector has a clear hierarchy in terms of quality; with the majors; Rio-Tinto, BHP and Woodside at the top, Fortescue, Santos and Oilsearch in the middle and the junior players such as Atlas Iron and Sundance Energy at the bottom.
A number of factors contribute to a quality resources company:

  • Quality of the resource
  • Cost of production
  • Proximity to distribution channels and final buyers
  • Low gearing (more so than other sectors)

The two charts below both paint similar pictures. Smaller players, who have much higher costs of production than the majors due to economies of scale and usually gear much more aggressively, are highly leveraged to rising commodity prices. This leverage is an investor’s friend until it is not, and as value-investors, the longer term proposition of these companies is not compelling. A quick look at the ASX’s delisted webpage will show a graveyard of smaller resource companies who simply cannot survive in a $50 iron ore and $40 oil world.
It is easy to see why debt is a tantalizing prospect for small resource companies. As commodity prices rise, profits and cash flow significantly ramp up as the company goes from just break-even to making significant margin on each unit of its commodity sold. The banks and other financial institutions will then open up further lines of credit as prices continue to rise. This all continues until commodity prices begin to fall and the leverage which propelled the share price on the upside, crushes it on the downside.
So, whilst quality may not entail impressive returns in the resources sector, it certainly acts to protect one from capital losses. Whilst the majors have barely returned anything to investors over 10-15 years, investing in quality in this case is the difference between having static capital for a decade versus losing it all.
Figure 4. Rio Tinto and Atlas Iron Total Returns + Iron Ore spot price ($USD)
Figure 4. Rio Tinto and Atlas Iron Total Returns + Iron Ore spot price ($USD)
Source. Thomson Reuters Datastream
Figure 5. Woodside Petroleum and Sundance Energy Total Returns + Brent Oil spot price ($USD)
Figure 5. Woodside Petroleum and Sundance Energy Total Returns + Brent Oil spot price ($USD)
Source. Thomson Reuters Datastream

Some final thoughts on quality, value and price

Warren Buffett once remarked; “Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” There is no doubt about the powerful compounding nature of quality businesses and Buffett has also said on occasion that he has become more comfortable paying a ‘fair’ price for quality as the market rarely marks down such companies. ‘Fair’ is the key word here, as everything has a price and quality can become too expensive, as can be seen in ANZ/CBA P/E chart. In the context of global bond markets and loosening monetary conditions, quality company’s valuations have become even more stretched in recent years.
In a market where quality is increasingly looking expensive, investors are faced with difficult decisions. Value investing teaches us that everything has a price, and often in the worst market corrections, it is the low P/E companies often trading below book value that have the least downside. However, when economies and the market recover they have the least upside.
Whilst investors should strive to identify and invest in quality companies, they should also be aware of how much they are paying for it to protect themselves from capital losses.