Sunday, September 09, 2007

It's Time for Quality

In a 1970's speech following Benjamin Graham, Robert G. Kirby made the following argument:

Economic analysis can be used to make investment decisions. In doing so, I would be inclined to concentrate my attention on two areas. The first would be in the determination of future, long-term interest rates. We have moved into an era where there are no longer two watertight compartments of "stock money " and "bond money." Equities and fixed income securities now compete for the same investment dollar. A critical factor in making good investment decisions is what the basic wage of capital is going to be in the future.

Second, I would try to determine whether we are in or entering a secular period of consumer spending or consumer saving. Because of the liquidity buildup during World War II and the post-war boom in the birth rate and in household formations, (I ought to reverse those) most of the decade of the 1950's and the decade of the 1960's was a period of consumer spending. Saving and capital formation took a back seat as a result. In recent years, we have seen evidence that we are at or near the production limits of our industrial capacity. If we are to have further real growth from this point on, we must enter a period of lower consumption and increased savings that will provide the needed capital to build new capacity.

However, these two factors — (1) future costs of long-term capital, and (2) whether we are going to be a spending society or a saving society – only influence security markets on a longer term basis. Therefore, knowledge of them is valuable only in an investment decision – not a trading decision.

Today, there is a knowledgeable camp of people (Hoisington, Zell, Watsa) who believe that long term treasury rates will continue downwards. In such an environment, it is the high quality company, one with strong competitive advantages, that will prosper as an investment. This is because in the long run, the market value of companies will track their growth in earnings. In an environment where long term treasuries yield 3%, it is the marginal company that will feel the most pressure on its Return on Investment (ROI), and hence earnings. Meanwhile, the high quality company will be better able to maintain its ROI due to the moat surrounding its business. So, finding a company that can maintain 10% long run earnings growth becomes much more valuable in a 3% discount rate environment than in a 7% setting. Such companies are difficult to find at a meaningful discount, but you can bet I'll be watching closely for anything if further market turmoil continues.

It is also interesting to note the second economic factor Kirby mentioned to watch out for: whether the future will be one of saving or spending. With the consumer "tapped" out and heavily indebted, it would seem that our future is one of savings. Such a shift could have a major impact on earnings; but again, it is the high quality company that will least likely feel these effects.

No comments: