7

REVIEW VOLUME 27

'Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.'Warren Buffett

'What causes an asset to sell below its value? Outstanding buying opportunities exist primarily because perception understates reality. Whereas high quality can be readily apparent, it takes keen insight to detect cheapness. For this reason, investors often mistake objective merit for investment opportunity. The superior investor never forgets that the goal is to find good buys, not good assets.'Howard Marks

'Keep it simple, and cheap.'Walter Schloss

'Success in investing is not a question of what you buy, it is a question of what you pay.'Howard Marks

Quality vs Price: Good Investments vs Good Businesses

At RECM, our primary aim is to buy what one thinks are quality assets cheaply. A quick glance at the biggest positions in our funds may cause investors to question whether some of these businesses fit the definition of 'quality'. After all, they currently operate in extremely difficult conditions and under severe pressure. Of course, the next query is often: if they are cheap, is there not a good reason why they'll stay that way indefinitely?

This article highlights RECM's definition of quality and discusses why, in the absence of quality businesses trading cheaply, the alternative of buying average businesses at low prices is a better strategy than buying even very high quality businesses at any price.

We aim to buy quality businesses at low prices

As value investors, when prices are substantially below intrinsic value, we become interested. When a low price is associated with a good quality asset we think we might have the makings of a good investment and we become even more interested.

These attributes of a good investment help us reduce the chances of suffering a permanent loss of capital in the following way:

· A cheap asset has a large margin of safety to cater for the possibility of our analysis being wrong. If the actual value is below what our analysis estimated it to be, then we might

not have any upside from the price paid, but, importantly, we have limited downside.

· A quality business can grow its intrinsic value over time, thus protecting investors who paid too high a price from losses.

Quality, much like beauty, is in the eye of the beholder. The popular perception of what constitutes a 'quality business' tends to change depending on what has done well in the recent past. Often this relates to how well the share price of a company has performed, rather than to the fundamental performance of the underlying company itself. For this very reason, it's important to have permanent criteria regarding quality and to stick with these throughout market cycles, ignoring subjective measures of popularity.

A quality business has high barriers to entry and generates excess returns over its cost of capital

At RECM we define a quality business as one that possesses an identifiable barrier to entry that enables it to produce returns over and above its cost of capital over time. This doesn't mean that it has necessarily done so at every point in its history – most companies have a cyclical aspect to their returns. At the very lowest points in the cycle some even deliver returns below their cost of capital. However, to be considered of good quality, they need to be able to earn excess returns through the cycle. These returns must also be due to an identifiable barrier to entry that protects

8

REVIEW VOLUME 27

those excess returns and not just due to that underappreciated factor in our lives, Lady Luck.

Importantly, as value investors, our largest position in a quality business would occur close to the lowest point in the company's business cycle. This is due to the fact that the market tends to extrapolate current conditions into the indefinite future. At a low point in the cycle, bad news is expected to continue, setting the scene for good news surprises, with a beneficial impact on the share price.

Table 1 shows the top ten holdings in the RECM Global Flexible Fund, our most flexible multi-asset class fund, (on a look-through basis) as at 31 March 2014.

Table 1: Top Ten RECM Global Flexible Fund Holdings (look-through basis) – 31 March 2014

Mar-14

Anglo American Platinum 5.3

Anglo American 5.1

Ultra Petroleum 3.8

BP 3.0

Arcelor Mittal Ltd 2.9

Impala Platinum 2.9

Arcelor Mittal SA 2.5

Microsoft 2.5

Lonmin 2.4

Inpex 2.3

Source: RECM

Figure 1: Matrix of Returns from Combinations of Price Paid and Business Quality

Source: RECM

Seven out of the ten businesses in Table 1 meet our definition of quality and many also happen to be at low (read: difficult) points in their business cycle and are thus cheap. The platinum producers are a good example of this – businesses that have achieved excess returns over their cost of capital in the past and we believe will again be able to do so in future. After all, they own a very large portion of the world's platinum reserves. This gives them access to a resource which the competition cannot replicate, a very sound barrier to entry.

In the absence of quality businesses trading cheaply, the answer is not quality at any price

When structuring a portfolio, we have to position for the best potential excess returns while protecting against the risk of permanent capital loss. In considering our two primary criteria – cheapness and quality – it's the first of these that a value investor cannot under any circumstances compromise on. The simple reason for this is that the price/value relationship has the biggest impact

9

REVIEW VOLUME 27

on returns. In other words a sensible heuristic is: always buy cheaply. Buy quality businesses cheaply when they're available – this is first prize. But buying average businesses at very low prices is a worthwhile strategy in the absence of cheap high quality businesses. Even in the case of what turns out to be a poor quality business, paying a low enough price will help to protect you against the risk of permanent capital loss. To demonstrate this, consider the matrix shown in Figure 1.

The middle block denotes the asset under consideration, which we assume to have a value of 100.

Blocks A, B and C on the left represent three scenarios for price paid:

A. a good/cheap price at 60% discount to the intrinsic value of the business;

B. a neutral price at intrinsic value; andC. a poor/expensive price at three times intrinsic

value.

On the right side of the diagram we consider three businesses of differing quality:

1. a very high quality business that's able to grow its intrinsic value by 15% per annum or 9% above inflation for seven years, resulting in its intrinsic value increasing from 100 to 270.

2. an average business that grows its intrinsic value in line with inflation at 6%, resulting in an intrinsic value of 150 in seven years' time and

3. a poor business that suffers from unfettered competition, where all economic benefits are competed away, or accrue to its clients. This business cannot grow its intrinsic value and in seven years' time, it's still worth only 100.

The shaded blocks on the far left of the diagram show the investment returns delivered through various combinations of these two criteria of cheapness and quality. Ideally, one seeks to invest in high quality businesses trading cheaply. This quite clearly gives the best possible outcome, returning 31% per annum (outcome A,1) if you can buy it at a 60% discount to intrinsic value. High quality businesses also have the lowest potential downside, returning only -2% if you happen to have miscalculated the intrinsic value and end up overpaying for the stock. (outcome C,1)

As the matrix demonstrates, the poorest range of returns (-2% to -14%) is achieved by investing in any of the three levels of quality businesses (1, 2 or 3) at an expensive price (C). Even investing in a high quality business (1) that's able to grow its intrinsic value at 15% per annum turns out to be a poor investment delivering -2 % per annum if you pay an excessive price for it (C). Indeed, it's often the highest quality businesses that reach multiples of intrinsic value at the top of the cycle, given the surge of interest, popularity and momentum they enjoy at that point. On the other hand, buying even a lower quality business (3) at a 60% discount to intrinsic value (A) delivers 14% per annum (A,3) – a real return of 8% per year.

An average business can be a good investment if you pay a low enough price

Consider Arcelor Mittal – the steel producer represented in the top ten by both the global holding company (Arcelor Mittal SA) and its South African subsidiary (Arcelor Mittal Ltd). In Daniel Malan's article 'Steel Schmaltz' (REVIEW Volume 24, April 2013) he explained that steel production is a very fragmented industry with a relatively consolidated raw material supplier base (iron ore). This implies that steel producers don't have significant pricing power over their products and are vulnerable to a classic margin squeeze. This is exactly the situation they've found themselves in over the past five years. As the demand for steel has declined due to the economic downturn, prices have come down. At the same time, iron ore prices have stayed high resulting in a squeeze on profit margins and lower profits.

Both the global and South African versions of Arcelor Mittal have several characteristics that elevate the businesses above their peers. They're in a better position to survive a long trough in the business cycle than many of their counterparts thanks to several factors, including:

· low levels of financial gearing; · vertical integration into their own raw material

supply chain; and · particularly in the case of Arcelor Mittal Ltd, a

strong position by virtue of their inland location next to a well-established domestic customer base. This localised monopolistic position provides them with some competition.

10

REVIEW VOLUME 27

Despite being among the better businesses within the steel industry, based on our definition of quality, both Arcelor Mittal companies are average businesses. Over time, they've earned returns broadly in line with their cost of capital through the cycle and operate in an industry that doesn't have significant, sustainable barriers to entry. But when purchased cheaply at current cyclical lows, when negative sentiment is at its peak and the businesses and broader steel industry are under extreme pressure, we have conviction that these 'average businesses' will turn out to be good investments. Indeed, despite continuing negative news in the sector, both stocks have already shown promising results with the share prices of both up more than 30% from their lows last year. We don't profess to know when mispricing will correct, but we do know through experience that when you buy stocks at cheap prices, more often than not, good things tend to happen.

A good business can be a bad investment if you pay too high a price

Most investors today would be of the opinion that pharmaceutical giant Johnson & Johnson is a quality business, no doubt aided by a stellar performance in the stock market over the past few years. This hasn't always been the case. During 2010, Johnson & Johnson faced several challenges, including a global economic downturn, loss of patent exclusivity on some of their major products, and a painful recall of 43 over-the-counter children's medicines across 12 countries. The negative headlines following the recall placed considerable pressure on the share price.

Despite these headwinds, the company reported respectable financial results at the end of the 2010 financial year with continued earnings growth. In fact, for the ten years to 2010, the company reported earnings per share growth of 11% per annum and dividends grew at a handsome 13% a year. Despite this solid delivery from the underlying business fundamentals, the share price returned only 2% per annum for the same ten years.

Since 2010 however, the share price has delivered 14% per annum for the three years ending 31 December 2013. Interestingly, the fundamentals of the business over the same three years have been decidedly lacklustre in comparison to the earlier period, with minimal earnings per share growth of 0.2% per annum. The reason for this glaring difference in share price performance over the two periods is obvious to value investors such

as ourselves. In 2000, at the start of the ten-year period measured, the share was expensive. In 2010, the share was cheap.

Table 2: Johnson & Johnson Fundamental and Share Price Performance for the Periods 2000 to 2010 and 2010 to 2013

2000 - 2010

2010 - 2013

Dividend growth rate (annualised) 13% 7.1%

Diluted EPS growth (annualised) 11% 0.2%

Share price returns (annualised) 2% 14.0%

Price-to-book at start of period 7.8 2.9

Source: RECM

Using a valuation multiple such as the price-to-book value ratio (P/B), it's evident that in 2000 the P/B was high – more than one standard deviation above its 20-year average. By 2010, after the share price had done virtually nothing for ten years, the fundamentals had finally caught up to the lofty expectations embedded in the valuation at the starting point. By this point, the P/B had fallen to less than half the 2000 value and more than one standard deviation below the 20-year average. At these levels, Johnson & Johnson, which had remained a good quality business throughout, could once again be considered a good investment.

Buying cheaply is critical to protecting against downside risk

Any business can face unforeseen circumstances that impact it negatively. Adverse conditions are difficult to predict and no amount of advance planning can completely insulate management from these so-called 'negative event surprises' – they just happen. And if management cannot foresee such events, analysts are in an even worse position. As Charlie Munger said 'the dawning of wisdom is when you realise that you know nothing'. If this were not true, asset managers would simply bet the house on one or two stocks every year. The reality is that it's virtually impossible to sidestep every loser, irrespective of the quality of research or level of insightful analysis.

What we do know however, is that the best way of stacking the odds in favour of limiting the losers is to pay low prices for the businesses you invest in. If you're paying a low price, chances are the business is out of favour at that time, and expectations are thus low. If expectations are low and the business

11

REVIEW VOLUME 27

Chart 1: Johnson & Johnson Share Price and Price-to-Book Ratio

Source: Thomson Reuters Datastream

continues to report disappointing news the effect on the share price is often minimal. The market has already anticipated bad news and has no need to knock the price down much further. Conversely, when a low expectation stock surprises the market with good news, the price can rise quickly and dramatically. This asymmetrical payoff profile stacks the odds in the investors' favour through generating good returns over time while limiting permanent capital losses.

In conclusion, a good business is not a good investment if you pay too high a price for it. But an

average business – or even a poor business – can be a good investment if you buy it at a low enough price. Ideally, we prefer to invest in high quality businesses when they're cheap. In the absence of these opportunities however, buying average businesses at very low prices is a better strategy than buying quality businesses at any cost.

Linda Eedes