Is Quality Investing Dead?

During their recent episode, Jake Taylor and Tobias Carlisle discussed Is Quality Investing Dead? Here’s an excerpt from the episode:

Quality shares are lagging behind the S&P 500 more significantly than they’ve done for over two decades.

The only other time, it happened April 1999, and we both know what came next. Everybody knows what came next. Does it feel like he’s capitulating at the wrong time?

[Jake] I mean, listen, who knows? I mean, you don’t know if it’s 1999 today or if it’s 1996, and you’ve got way more to go. Who knows?

I mean, I’m not that clever to know the answer to those kinds of things, but… Respectively, yeah. But, you know, I mean, quality had such an amazing run for a really long time.

Everybody kind of all got on the same side of the boat of, listen, you don’t want to own bad businesses going into a recession that always felt like it was right around the corner. Obviously. Like, what kind of idiot would own bad businesses?

[Tobias] Don’t own bad businesses.

[Jake] Yeah, but then that got taken to extreme. Like, anything that was a smart idea taken too far turns into a dumb idea. You know, I’m paying whatever, 60 times for something like Costco or…

I mean, if you looked at his portfolio, it was full of things that were 2%, 3%, at best, maybe 4% free cash flow yields. Like, it was expensive for the most part. And they were good, obviously.

But, you know, I mean, that coming in some probably shouldn’t be a huge surprise to anybody, right? Like, that’s just kind of how the world works. What’s it going to go to a 1% free cash flow yield?

How expensive is the quality justified at some point? Like, it kind of stops making sense. So, I don’t know.

It’s a shame. I mean, I’m happy to… It’d be nice if a lot of them really went on sale and then you could trade up into a super high-quality basket for the next stretch of the track.

That would be ideal.

[Tobias] When he says momentum, does he… Do you think he literally means share price momentum? Or is he saying, I want more growth in the businesses?

Because, you know, if you look at a lot of those businesses, they are very high-quality businesses, but they don’t have a great deal of growth in them. From my perspective as a quantity kind of value investor, lack of growth isn’t something that particularly bothers me, because if you sort on growth, you tend to underperform. The growth is not a great predictor of board returns, or it hasn’t been previously.

It’s another one of those scenarios where what has worked for 100 years and been true has not been true for the last 10, and has not been true periodically over that 100 years, but on six occasions, including the current one, all of which were around technological revolutions that resulted in very rapid share price growth for a select few companies that were fast growers to the, you know, led everything else to underperform, and particularly things with a lot of growth.

So those companies, I think that growth is a good thing. A little bit of growth is a good thing. It’s good to be going ahead a little bit, but you don’t need a great deal of growth.

You can have a very high return business that pays out most of its earnings, provided it’s not really going backwards in real terms. It’s still a very good business. You can make a lot of money on that, particularly if the management team is doing something about it, buying back stock.

That’s a really strong signal, has been historically. I don’t know.

[Jake] I think it’s been- That’s fun staying poor with that idea.

[Tobias] I have a great deal of empathy for what Terry Smith is going through, because I’ve been going through the same thing for an extended period of time, and it’s psychologically difficult, and it makes it, I can understand the urge to change position. And I think the only thing that saves me is I always return to the research and I try and find a way out of the problem a million different ways. But I’m looking at a whole data set- Spinning around in academic circles.

Yeah, just a rat in a maze trying to find a way out, but unable to find the exit.

[Jake] I think what we need is we need a meme where it’s that James Franco, and he’s up on the gallows, and it’s like, you’re James Franco, and Terry’s the other guy. Oh, first time on here.

[Tobias] I think that, but I also think that being research-driven helps, because I mean, we’re saying this at the absolute bottom of this, maybe not the bottom, but like from the bottom of a hole. So this could be completely wrong. I look back on this in three years’ time and say, gee, I wish I had a little bit more momentum in my portfolio.

But I do think that it’s ahistorical, although the history is getting longer and longer. It’s 10 or 15 years of not working.

[Jake] So yeah, maybe- Half a career is, doesn’t look like much on the chart, right? But 15 years living it is a completely different experience.