Someone approaches you with an offer. They want to sell you part of their company. You take a quick look at their metrics. They’ve got more debt than they can afford, especially if interest rates rise. Cash flow is weak and there is little prospect for meaningful earnings growth over the next 10 years. They have some hard assets on the books but those assets might carry heavy liabilities or even be worthless going forward. The pitch? It’s cheap.
Would you buy?
What if they sweeten the deal for you?
They point out that there is $3 to 5 trillion in cash on the sidelines in today’s economy. With most of that cash earning close to 0%, investors eventually must buy something just to keep up with inflation. Given additional Federal stimulus being injected today, the possibility of a massive infrastructure plan, the Federal Reserve’s commitment to keeping interest rates low, and Congress’s need to maintain low-interest rates given the country’s debt load, it seems likely that this flood of liquidity will continue for some time. As such, it stands to reason that eventually investors will be buying this company, too.
Need more sweetening?
They observe that many participants in the market must buy the company because that’s how they invest—they buy everything. These are participants like index funds (or actively managed index mimics) who buy the equity, debt, or hard assets of all the companies of a certain size, sector, or style no matter how good they are. They buy the good and the bad with the assumption that it all gets to the same place anyway. These buyers are not dissuaded by the financials, have plenty of cash on hand, and are more focused on the ends than on the means. Because they buy relatively indiscriminately, these investors buy more of what everyone is buying. As long as everyone is buying, they are in with you. In with a penny in with a pound. Until they aren’t of course.
Still, with this compelling flow of capital into the company, wouldn’t you want to have a chance to participate? You would have a position you can get on the cheap and the confidence that the markets are awash in liquidity and non-discriminating buyers.
Ready to whip out that checkbook? Wire those funds? Leverage that balance sheet?
Ah, if only it were that easy!
Of course, there are times like November 2020 – February 2021 when lower quality investments outperform their higher quality peers. Often, those periods coincide with the first months of emerging from a recession, as in 2003, 2009, and the tail end of 2020. Those lower quality names often had performed relatively poorly during the period preceding their return to glory and with good reason. With weaker balance sheets, cash flows, and revenue growth, recessions and fear often hit those companies hardest. As recovery provided a light at the end of the tunnel, those companies got some breathing room and their investors hoped for a nice, if short-lived, ride back.
Over longer periods of time, some of the best managers are those that prioritize quality in their due diligence efforts. While there is no single definition of “quality” that all investors agree upon, such companies generally demonstrate healthy balance sheets, compelling earnings growth, strong management, and a business plan that bodes well for continued success. Managers who consistently seek out, identify, and invest with such companies have tended to produce investment portfolios that have earned their fees and then some, and quite often with an inherently less-risky posture than their peers.
It can be hard to stay focused on quality in an environment when it feels like quality no longer matters. Look at GameStop (both long and short depending on the week). Look at Bitcoin. Tesla. Watching the headlines, it can feel as though all the cool kids are at Miami Beach partying without masks while only a fuddy-duddy would hang out in a more secluded place with just a few select, safety-conscious friends. This sense of “everyone’s doing it” can be problematic for investors worried about being left behind or missing the next shiny penny. Rather than focusing on making sound strategic decisions, they can be tempted into following the crowd into investments that simply do not make much sense.
In 2019, when Syntrinsic put to writing our Investment Philosophy, we made “Quality Matters” one of just four statements of belief. Through 2019 and most of 2020, that proved easy because generally speaking, higher-quality companies significantly outperformed their weaker peers. As good news about vaccines led markets to rotate in favor of lower quality names toward the end of 2020, we took a deep breath. Over the past decades, we have seen investors lose their cool in low-quality rallies just as some investors have lost their nerve in broad market declines. The markets we are in today require as much willpower and commitment to quality as the markets we experienced one year ago as the pandemic swept across the globe.
There are many ways to invest. We focus on quality. It is the “intrinsic” in Syntrinsic. All companies have intrinsic value based on their earnings, assets, differentiators, people, and ability to execute. Focusing on that intrinsic value provides a framework for evaluating risk and determining the price one is willing to pay for future earnings and/or debt payments. Quality empowers investors to navigate environments frequently defined by hype, fear, and greed. It serves as the intellectual justification for the patience and discipline that we all know is so important. Especially when someone approaches us with an offer.