In the academic world there is a basic financial theory according to which the relationship between profitability and risk is positive, that is, the higher the profitability, the greater the risk, and vice versa. This makes sense in any other area. Difficult (risky) things are usually the ones that bring us the most satisfaction. Getting the opposite (higher returns with lower risk) sounds like a panacea, theoretically impossible to imagine. But the truth is that it is possible.
You can get higher returns with lower risk. Investing in quality companies has repeatedly shown to be capable of achieving better returns than the rest of the market with a much lower level of risk. When we talk about a quality business, we refer to a series of characteristics that make that business a good business. The features that matter most to us are:
1. Income growth. We prioritize organic revenue growth over any other income statement metric.
2. Profitability. Growth is worthless if it is not profitable. In the same way that profitability is of no use to us if there are no opportunities to continue growing and continue to create value in the long term. And the most important metric for this is the return on capital employed (ROCE).
3. Competitive advantages. Growth and profitability evaporate if there are no competitive advantages to keep the competition out. The longer a business manages to maintain a high growth rate and an attractive profitability, the more value it can generate for its shareholders in the long term.
4. Financial structure. Having an adequate financial structure is vital to guarantee the survival of the company and to be able to face stages of uncertainty (Covid-19) or take advantage of investment opportunities to continue growing (investing in new products or markets or acquiring companies that complement the business ).
5. Therefore, quality companies are those that grow on a recurring basis in any market environment, that are capable of obtaining very attractive returns and have strong competitive advantages that prevent new competitors from entering and take market share away from them, that the business can sustainably maintain high returns and can reinvest them to continue growing. In addition, with an attractive financial structure, these businesses avoid any financial commitment that puts the survival of the business in doubt, especially in times of weak economic cycle, when demand falls and profits suffer.
A company with these characteristics is not only more secure, but is also capable of achieving better returns over time. On the risk side, a company with a better financial structure, with a leadership position, capable of offering better products or services and with a resilient business model, capable of operating in any market environment, is a guarantee of security, even in times of uncertainty, since they are businesses with enormous visibility. Furthermore, in times of economic weakness, these businesses tend to come out stronger and tend to grab more market share from other businesses that are unable to survive. On the profitability side, the price of a company is a faithful reflection of the creation of long-term value, and the businesses that create the most value are those that are capable of constant growth at high rates and offer high returns on the capital invested.
However, valuation is another important factor to consider when investing. Even the best company can become the worst investment if we pay too much for it. However, when facing the valuation of a business we must take into account the market environment. In other words, interest rates and the valuation of risk-free alternatives (American bond or German Bund) affect when deciding whether or not the valuation of a business is attractive. Paying a 3.5% Free Cash Flow yield for an excellent company like Microsoft makes sense if the yield on the bond is less than 1.0%. As soon as the yield of the bond is above that FCF yield, it would not make sense to pay 3.5% for Microsoft when we have a less risky alternative that returns the same yield.
In any case, we cannot sacrifice quality for valuation. Seemingly expensive quality companies get cheap over time as they continue to grow and improve their fundamentals. In 2015 Amazon was trading at 534x PER. His profit was only 596 million dollars. However, Amazon’s profit in 2020 was 21,331 million (+ 3,479%). This means that, really, in 2015 we were paying only 14.9 x PER for Amazon’s 2020 profits. And the price has reflected that value creation (+ 330%). The opposite case can be that of Banco Santander. In 2015 the market paid 10.4x for the benefits of Banco Santander, when then it earned 6,832 million euros. But, unlike Amazon, Santander lost 7,414 million euros in 2020. So that PER of 10.4 x 2015 has been very expensive (Banco Santander’s price has plummeted -42% between 2015 and 2020).
Ultimately, quality businesses allow better returns to be achieved while assuming less long-term risk. The price we pay for that quality should be attractive, but we should never put valuation before quality. Meeting endpoints while neglecting quality is one of the most dangerous long-term strategies. The best strategy in terms of return / risk has been and will continue to be investment in excellent companies in the long term.
Alvaro Jimenez is Equity Manager at Gesconsult
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