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um first of all what is value investing you see this phrase banded about an awful lot um it's about buying a stock below its intrinsic value what's the intrinsic value of a business which most people would say uh amounts to the discounted present value of its future expected cash flows in some form how much cash will it generate over it over Horizon and discounting that back to present value is roughly it the kind of the the father of of value investment is Ben gray uh he was the author of uh security analysis and the intelligent investor and famously taught Warren Buffett in his time at Columbia University and of course his pupil Warren Buffett who uh certainly in his early years of running barire Hathaway was an aderant of value investing of trying primarily to buy a stock below its its intrinsic worth um it's in my view becoming correctly associated in more recent years by other practitioners with the Simplicity of just buying things which are lowly rated that people look at simply the low valuation they don't do the bit about looking at the valuation versus the intrinsic value because of course something can be lowly valued but not lowly valued enough if it's a poor business um this kind of illustrates that point I think this is an interesting chart in my view it takes a number of stocks uh all of the sort that we seek to invest in at fundsmith so things like consumer stable stocks in particular you see heavily represented here some consum discretionary stocks and it looks at the you could have paid if you bought these stocks at the beginning of 1973 and held them through to 2019 so a pretty long period a period with uh inflation and then deflation uh with a number of recessions and crisis have very so a pretty long sweep of investment history and it says during that period the msci world index delivered a return of 6.2% R and what we've got here is somebody who's gone back and computed what PE or Price earning ratio you could have paid for some of these stocks and beaten that index what could you have paid and got a 7% compound annual growth rate in the value of your Investments so you see that at the top of the chart 7% cagr and you can see in 1973 you could have paid 281 times L'Oreal's earnings that year and still beaten the index over the period down to 2019 you could have paid 126 times for Colgate and you could have paid 100 times for pepico um and you see the people who really a DEA to Value investing is equally low as equally low valuation missed the point that presumably looking back at this now uh buying Laural less than 281 times earnings you were buying it below what seems to have been established as its intrinsic value that is an extremely important point which I think we are generally bad at managing to figure out um having said what value investing is what's quality investing which um we at fundsmith Endeavor to apply we're looking for companies with a High return on Capital this I I think is the primary measure of financial performance by company does it make a high return on the capital employed which after all as a shareholder you partially own you also need to look for a source of growth there's no good having high returns if you don't have anything to invest in in the future because most companies distribute about half of their earnings the other half that they retain is reinvested in the business in some form uh in this source of growth and that delivers incremental returns over the future it is the source of compounding which is the single uh characteristic of equities which in my view is not commented on enough equities are a unique asset class unlike any other asset class a portion of the return for the investor the cash flows of the earnings is retained by the company and reinvested on your behalf that doesn't happen in R it doesn't happen in bonds and also fundamentally we're looking for companies with a sustainable competitive Advantage this is the famous Warren Buffett mode it's no good having great returns uh if you are able to fend off the competition because otherwise the competition will enter your uh Market and drive your returns down towards the average or even possibly below so that's what we are seeking when we talk about um Quality investing um Buffet himself made a transition he started as a a value investor uh as a disciple of Ben Graham but people often forget that he was also taught in Columbia University by a man called Philip fiser who wrote a book called Common Stocks and uncommon profits and Philip Fisher was really disciple of the quality investing in the in the sense I've describ it looking for companies with high returns and a source of growth in which to reinvest to compound in value he was also very affected by Charlie Munga the vice chairman of barkshire uh who I think has got more of a vent towards quality investing and value investing which you'll see in some of the quotes I'm going to give you um Buffett himself agrees with us I think on the primary measure of of what's a quality business High return on Capital here's a quote from his 1979 annual report to investors uh in bsha where you see he says the primary test of managerial economic performance is the achievement of high earnings rate on Equity Capital employee a high return on Equity Capital employee this is in his view the primary measure of performance now since he wrote that in 1979 it's been almost universally ignored by the investment uh industry I always say I have a blind bet with people who are the recipients of investment research about our companies uh and if they pick out 10 random pieces of research how many of them those 10 will say that the thing that we should most look at in this company that's being analyzed is return on Capital I I'll bet you that none of them say that I'll have a blind bet of the sort of statutory here I know five euros with anyone watching this that on the other hand when they've lost that bet to me and I think they will lose it I'll give them what they call a double equips opportunity I'll bet you that all 10 of them mention earnings for share you'll see the buffets quote goes on to say the primary test is not the achievement of consistent gains in in earning the share which people of course obsess about whereas they don't give much consideration to the return on Capital employed um here's a another quote this one is from manga who as I say really uh drove Buffett I think or helped to drive Buffett towards quality investment over the long term it's hard for a stock to earn a much better return than the business which underlies it earns I don't know why he picked this period on these numbers but he says if the business earns 6% on Capital over 40 years and you hold it for that 40 years you're not going to make much different than % return and this is the punchline even if you originally buy at a huge discount so if you're buying it as a value investment conversely if a business earns 18% on Capital over 20 or 30 years even if you pay an expensive looking price you'll end up with one hell of a result he's saying look at the quality of the returns in the business not at the price here's an illustration of why Manga is right
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