Quality Will Withstand

Quality Will Withstand
By Paul A. Larson
Morningstart, 08-09-06

One of my favorite Warren Buffett quotes is, "It's only when the tide goes out that you learn who's been swimming naked." In the early part of 2006, it seemed that many were swimming in their birthday suits in the strong economy's high tide, plowing into everything from risky commodity companies to emerging markets with abandon. Now that the markets have taken a breather since May and the tide has started to roll out, the benefits of investing in wide-moat firms have made themselves more evident.

A booming economy like we've experienced in the past couple of years covers up a lot of sins made by marginal companies. Meanwhile, the types of companies we own in the Tortoise and Hare portfolios in StockInvestor--ones that have wide economic moats--are not economic sinners. They are like the tallest trees, withstanding the wildfires that occasionally wipe out the weaker or poorly positioned competitors.

The companies we own at StockInvestor may not partake in the party created by a strong market rally, but I strongly suspect they will hold up much better when an economic downturn hits. And a downturn will indeed hit … eventually. As the saying goes, "If something cannot go on forever, it will eventually stop."

I don't mean to sound like an alarmist, but the worldwide economy will slow down from its recent record pace at some point. I am not certain what the catalyst will be--perhaps China will consolidate its white-hot growth of the past couple of years, maybe high energy prices will hit the economic brakes, or the two-headed monster of inflation and higher interest rates might mop up all the worldwide excess liquidity. I don't have any reasonable projection when the clouds will come, but come they will.

I am not worried. The companies we own in our Tortoise and Hare portfolios are well-positioned for nearly any economic condition short of a world war. And for those portfolio holdings that do have some meaningful economic sensitivity, we have given ourselves a sufficient margin of safety by modeling a significant decrease in sales and earnings into our discounted cash-flows.

Just think of investing as taking a long, cross-country road trip with other investors. Those who forgo the tire chains, spare tire, emergency supplies, and pre-trip mechanical checkup may be able to leave sooner and, with less weight, possibly drive faster--when the weather is good. (Or as Buffett might say, there is no need for swimsuits at high tide.) But when some bumps in the road appear and it starts to snow, those who planned ahead for the longer term will get the last laugh. We expect the companies we have bought to hold up much better than average over the long haul.

Last spring, my colleague Pat Dorsey (Morningstar's director of equity research) published a very interesting article titled "Buy Quality, Buy It Now." In his studies published in late April, Pat found a direct correlation between a stock’s riskiness (as measured by Morningstar’s business risk rating) and its three-year trailing return. The riskier the company, the better the trailing return. He found a similar phenomenon with the economic moat rating. Those companies without a moat had far outperformed those we have rated "wide."

I am here to preach patience, since I think it is only a matter of time before this trend reverses, particularly on the moat side. Almost by definition, companies with wide economic moats earn large returns on their invested capital, while those with no moat tend to earn low returns. Over very long periods of time, a company's returns on capital will drive its stock price.

Companies with no economic moat can occasionally earn oversized returns when the economy is good (like today), but the profits are usually fleeting. Meanwhile, I'm highly confident that nearly all of the companies we own in the Tortoise and Hare portfolios will continue to earn high returns on capital 10 years from now and will have significantly larger earnings streams at that time. This is what is truly important in investing--the long-term cash-flow-generating power of a company, and its ability to defend those cash flows. Focus on this, and I think your returns will be much better.

The good news is that the recent down draft in the stock market has caused a large number of high-quality companies to trade at very compelling prices. Whether it is Johnson & Johnson JNJ , Microsoft MSFT or Berkshire Hathaway BRK.B , I think our investments in the Tortoise and Hare will hold up well no matter what happens to the economy.