Friday, March 25, 2016

Investing in a high-quality business...

From Capital Returns:
Investing in a high-quality company can seem dull and unrewarding in the near-term. The lower risk which comes from investing in quality companies is only properly observed over the long-term. The fact that investors are often focused more on the short-term is partly a function of psychology – the human brain is simply not attuned to multiyear planning, being far better at responding to short-term threats and stimuli. This is seen in several behavioural heuristics – notably hyperbolic discounting and recency bias. Short-termism can be intensified in an institutional setting. Performance-related pay for money managers at most investment firms is weighted to annual performance, which discourages long-term thinking. 
Finally, there is another more technical reason why the virtues of a high return business are not always fully appreciated by investors. This is the tendency of investors to focus on the income statement. This fosters a fixation on price-earnings (P/E) valuation metrics and not price to free cash flow (P/FCF). Thus, all earnings growth is seen as equal, even though it is materially more value creative when return on capital and cash flow generation is higher. Faced with a choice between investing in two companies with the same earnings growth, we are prepared to pay materially more (in P/E terms) for the business with high returns on equity and superior cash flow generation.