June 06, 2024 | Institutional Perspectives | 9 min read
Our Approach to Value Investing: Quality Matters (& Can Be Worth Paying For)
Warren Buffett is often described as the ultimate value investor. The “Oracle of Omaha” certainly deserves that moniker but what he and Berkshire Hathaway practice is much more nuanced than simply buying cheap stocks. Indeed, in his 2024 Shareholder Letter, Buffett reflects on an early conversation with his late, great, partner of many decades, Charlie Munger, that describes how Munger helped him evolve his approach from what he called in his 1989 letter “cigar butt” investing, to his current approach:
Charlie, in 1965, promptly advised me: “Warren, forget about ever buying another company like Berkshire. But now that you control Berkshire, add to it wonderful businesses purchased at fair prices and give up buying fair businesses at wonderful prices… With much back sliding I subsequently followed his instructions.
- Warren Buffett, Berkshire Hathaway Shareholder Letter (2024) (emphasis mine)
Charlie believed valuation mattered but that investors should focus on high-quality companies that have a sustainable competitive advantage. Charlie would say that “some businesses were worth paying up a bit to get in with for a long-term advantage.” This led to a shift in Buffett’s investment philosophy, and he moved away from cigar butt investing towards investing in above average companies while remaining cautious about valuation.
The Nuances of Value Investing
We believe our approach differs to some of our value peers in that we agree with Warren and recognize there are certain companies worth paying a premium for. When we think about some of the best performers in our portfolio over the years, a number of them are stocks that were never statistically cheap on a Price to Earnings (P/E) basis but were undervalued franchises.
A perfect example is Constellation Software, which we have owned since it went public in 2006. When we originally invested in the company, it would not have stood out as a traditional value stock; however, we recognized the power of their business model of acquiring mission-critical software companies with high switching costs and limited competition. The companies in Constellation’s portfolio have very sticky, recurring revenue with low economic cyclicality. These features make it a valuable long-term holding in portfolios irrespective of market conditions. Looking back at difficult markets including 2008 and the Spring of 2020, Constellation’s resilient business model provided protection for our clients, posting positive returns in those periods. From the IPO through the end of 2023, Constellation stock rose by more than 35% per year – or over 19,000% (source: Bloomberg).
Howard Marks, one of the co-founders of Oaktree Capital Management, captured this concept well in his memo to investors back in Jan 2021, which he titled “Something of Value.” “Value investing doesn't have to be about low valuation metrics,” he wrote. “Value can be found in many forms. The fact that a company grows rapidly, relies on intangibles such as technology for its success and/or has a high P/E ratio shouldn't mean it can't be invested in on the basis of intrinsic value… If you find a company with the proverbial license to print money, don't start selling its shares simply because they've shown some appreciation. You won't find many such winners in your lifetime, and you should get the most out of those you do find.”
Valuation is a key focus of ours, but we recognize quality can be worth paying for - you just need to be careful about how much you pay. While we are willing to own Constellation Software at a valuation higher than the market, we were never comfortable paying the premium Shopify traded at several years ago. Figure 1 shows some analysis we conducted in August 2021 when Shopify* was trading near its highs. At the time the company was 14 years old and was being valued at over 50 times Sales. We then looked at how that expected growth from year 14 to year 24 compared to what other great growth businesses achieved over similar periods in their history.
Figure 1: Sales growth for technology giants in years 14-24 of their history
* Shopify sales based on Leith Wheeler estimate of growth implied in valuation.
** Google sales include consensus estimates for 2021 and 2022; Netflix sales include consensus estimates for 2021.
It was sobering to realize that even these great companies did not achieve the growth the market was expecting from Shopify which was pricing in sales growth of 31 times over the next ten years. As their shareholders have unfortunately realized, Shopify’s growth ended up disappointing the market and the stock has now fallen significantly from its high!
Figure 2: Shopify stock price, January 2021 – June 2024
While it can be difficult to perfectly classify your investment style based on a single metric (e.g. Price to Earnings), our approach might fall in the following range:
We do not use P/E to purchase stocks. We focus more on the intrinsic value of a company, using discounted cash flow models and judgement. We then look to buy them at a price we determine is significantly lower than that intrinsic value. This can include owning exceptional businesses like Constellation at a P/E higher than the market; however, our overall portfolio will always be reliably inside “value” territory in aggregate.
Protecting Capital
A key measure of an investment manager is how they perform through difficult markets, so avoiding the hype that can build around certain stocks over time is key. Shopify is the perfect example of a good business that burned investors who abandoned their price discipline on the run up, when it eventually fell off its peaks in 2022. In addition to improving the potential long-term returns from a holding, buying companies for less than intrinsic value gives us a margin of error if events do not go according to plan. Our bias towards conservatively financed companies with good management, strong competitive advantages, and proven track records also helps improve our chances of success.
The Downside Capture Ratio (DCR) measures a strategy's performance in down markets relative to its benchmark. A value below 100 means that the strategy has lost less than the S&P/TSX Composite during periods of negative returns for the benchmark, and over 100 means it has lost more – so lower is better. Figure 3 shows the DCR for the Leith Wheeler Canadian Equity Fund versus the S&P/TSX Composite over the last four years, and since its inception nearly 30 years ago:
Figure 3: Downside Capture Ratio for Leith Wheeler Canadian Equity Fund
*Inception date Q3 1994
As the table shows, our Canadian Equity Fund has protected capital significantly better than the S&P/TSX Composite in down quarters over both the medium and long term. Launched in 1994, the fund has navigated several very challenging markets including the Tech Crash, Financial Crisis, European Debt Crisis, and COVID-19. We are proud of our history of protecting our clients’ capital.
Taking Our Approach Global
We launched an internally managed Global Equity strategy in November 2021 which follows a very similar investment approach to our Canadian equities. The Leith Wheeler Global Equity Fund is off to a good start, outperforming both the down market of 2022 and the frothy rebound in 2023 – despite having limited exposure to the “Magnificent Seven.” While many other value strategies struggled to keep pace with the market in 2023, we were able to outperform despite not owning market darlings Apple, Amazon, Microsoft, Nvidia, and Tesla. See Figure 4.
Figure 4: Leith Wheeler Global Equity Fund vs MSCI World - Net (C$)
Qualcomm is a holding we’re very excited about in our Global Equity portfolio. While the company is known mostly as a smartphone chip maker, it has a leading position in Edge AI that is really exciting. Due to the significant computing power required, AI models must currently be run in the cloud using Nvidia chips, but Edge AI allows computing and artificial intelligence (AI) functions to happen on your local device such as your smartphone, PC, or car. This can be particularly powerful in improving the accuracy, speed, and reliability of automotive applications like Advanced Driver Assistance Systems, where spotty 5G coverage and the natural latency of cloud-based AI may cost critical seconds in preventing a crash. Qualcomm is a clear leader in Edge AI with many years of R&D and completed integration of an AI processor into its chips. We anticipate meaningful adoption in the next 3-5 years. More broadly, Automotive represents a big opportunity for Qualcomm, where it has been leveraging its leadership in connectivity and chip design to expand its footprint in a sector that has enlarged the company’s served addressable market by seven times. Qualcomm already has a $30 billion automotive backlog.
We believe the market has yet to price in these secular growth drivers as the stock is trading at a very attractive valuation. As Qualcomm thrives in these new areas, we believe the stock price will be rewarded accordingly.
Value is in the Eye of the Beholder
If an investor ever describes their process as buying companies primarily based on their Price to Book or Price to Earnings ratios, without incorporating an assessment of intrinsic value, we would recommend looking elsewhere. This approach to investing is overly simplistic and can overlook great opportunities in terrific businesses which deserve a bit of a premium. It can also result in a portfolio full of lower-quality companies.
In some cases, a stock might look like a bargain, but it is cheap for good reason (i.e., a “value trap”). Perhaps its business is in permanent decline, it has a poor management team, an overleveraged operating model, or is losing market share. Avoiding these traps requires insight, judgment and humility.
Bill Wheeler, one of the founders of our company, used to describe our style as “careful, thorough and based on the idea that we would buy a stock if it made sense even if there was no stock market to buy it back”. In other words, we would only buy a stock if buying the whole business made sense. In our view, investment returns over longer periods are largely a result of the relative attractiveness and durability of a company’s business model and the future increase in the company’s revenues, earnings, and free cash flow. These are the key factors that ultimately drive stock returns over time - as long as you do not overpay going in.
So identify strong businesses, but be patient in buying them as they will become available at attractive valuations from time to time. Build a portfolio of companies with a demonstrated ability to consistently grow profits and generate high return on invested capital, but remain disciplined about valuation.
We agree with the late Charlie Munger that there are businesses worth paying up for a “bit” if the quality is there – just be careful how much you pay.
