Chapter 8: Become a Quality-Driven Value Investor
Chapter 8: Become a Quality-Driven Value Investor
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 8 of the serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real-time.
Chapter 8 answers why buying and holding the shares of enduring enterprises at reasonable prices via quality-driven value investing remains an ideal approach to alpha-achieving common stock investing.
Chapter 8
Become a Quality-Driven Value Investor
Most professions or disciplines require the mastery of no more than 6 to 8 fundamentals for sustainable success. Stock market investing is no exception.
As widely reported, many in the financial services industry and media consider buy-and-hold quality-driven value investing dead in the water.
If so, then why are many of the premier investors in modern history quality-driven and value-oriented?
William Browne, Warren Buffett, Mario Gabelli, Benjamin Graham, Joel Greenblatt, Seth Klarman, Peter Lynch, Howard Marks, Bill Miller, Charlie Munger, Michael Price, John W. Rogers Jr., Charles Royce, Walter Schloss, Sir John Templeton, Geraldine Weiss, and Martin Whitman are legends.
These value investor household names remind us of the practice of owning the common shares of enduring companies with wide safety margins, the most assured route to building alpha-achieving portfolios.
Anything with promise—and despite ever evolving and persevering—has its lapses in popularity or delivery methods. Nevertheless, there is no equal to quality-driven investing for individuals striving to build and maintain an enduring portfolio financing the indispensable milestones in the lives of loved ones.
Quality-Driven Value Investing Defined
I asked ChatGPT to define “quality value investing.” I found its answer aligned with what I seek in researching and writing about alpha-achieving opportunities for the Quality Value Investing newsletter and this book, emphasizing the company’s current wealth and the stock’s present value.
Quality value investing is an investment strategy that combines the principles of value investing with a focus on high-quality companies. This approach involves identifying undervalued stocks of companies that have strong fundamentals, including robust financial health, sustainable competitive advantages, and consistent earnings growth. The key aspects of quality value investing include:
Fundamental Analysis—Evaluating a company’s financial statements, such as balance sheets, income statements, and cash flow statements, to determine its intrinsic value.
Competitive Advantage—Investing in companies with a durable competitive edge, often referred to as an “economic moat,” which can include brand strength, proprietary technology, network effects, or high customer loyalty.
Management Quality—Assessing the track record and capability of a company’s management team to ensure they are capable of maintaining the company’s performance and driving future growth.
Financial Health—Looking for companies with strong balance sheets, low debt levels, and high returns on equity, or ROE, and invested capital, or ROIC.
Valuation—Identifying stocks that are trading below their intrinsic value, providing a margin of safety. This involves comparing the current stock price to the company’s intrinsic value derived from select valuation methods.
Long-Term Perspective—Adopting a long-term investment horizon, focusing on companies that can grow and generate value over time, rather than seeking short-term gains.
By emphasizing quality, investors aim to mitigate the risks associated with value traps—stocks that appear cheap but lack solid fundamentals. This balanced approach seeks to achieve steady, reliable returns by investing in undervalued yet fundamentally strong companies.
—ChatGPT, July 2024
On the Recurring Death of Value Investing
Value investing is never dead. It’s less popular than short-term growth stories and low-quality cigar butts. Investing in enduring enterprises at reasonable prices remains a superior strategy.
Although it is essential to underscore that I remain a die-hard, quality value investor, the investment paradigm was out of favor on Wall Street during the momentum growth post-Great Recession bull market. Hence, attracting readers taught by the financial services fee machine to place their trust in unreliable predictive analysis and business modeling overkill became more challenging.
Toward the end of the epic bull, it became vogue for long-time celebrity-named value investors to bite the bullet and buy the more speculative, non-dividend-paying growth stocks. In other words, this time was different until it wasn’t.
For better or worse, I passed on each trend and other momentum growers as speculation. Instead, I focused on researching and purchasing stocks of boring, out-of-favor, albeit excellent companies with histories of outperforming the S&P 500. The results were predominantly alpha-achieving.
Wall Street struggles to generate Hamptons beach house-size bonuses on buy-and-hold quality value investing. Instead, it promotes speculative trading paradigms, producing fees that build those summer cottages.
Of course, there are diverging interpretations of traditional value investing or multi-bagger compounders purchased at attractive prices.
Trading value stocks is the equivalent of buying cigar butts or shares of companies with questionable fundamentals on speculation and then selling based on anticipated, or worse, hoped-for corporate, industry, or macro-driven events. In contrast, quality value investors continue to add fresh ideas to their portfolios that offer compelling prospects for compounding capital gains and dividends, protected by adequate safety margins to preserve principal during the inevitable market declines.
As a reminder, future returns are often uncorrelated with past performance. Nonetheless, quality-driven value investing aims to outperform the benchmark over extended periods—seven to ten years or more—knowing monthly, quarterly, and annual performances are at the whim of the market’s voting machine cast from irrational investor behavior or the occasional surprise event. It is more profitable to seek the benefits of compounding returns protected by adequate safety margins.
The epic bull market of the 2010s and early 2020s decades seemed unstoppable, propelled by non-dividend-paying growth, high-yield forward dividends, cryptocurrency, and other near-sighted investment strategies. Some market luminaries questioned the enduring legacy of value investing or declared its imminent death. A bull market for the ages precipitated the argument as growth stocks, momentum trading, trend following, and forward high-yield dividend equities, among other speculative portfolio strategies, outperformed the more risk-averse quality value approach.
Quality value investing is too long-term and low-cost for a shortsighted, over-sophisticated financial services industry bent on collecting exorbitant fees and bonuses from its legion of followers. Nevertheless, trying to predict trends, catalysts, and macro events that produce profitable trades with consistency befits a game of chance more than a legitimate professional practice. Despite the noise, fundamentals and price-sensitive investing triumphs because quality at value matters in everything we buy, hold, or sell.
Investments in moated, predominantly dividend-paying companies at reasonable share prices endure well beyond the scrap heap, where perennial bull markets for the ages dump the portfolios of investors chasing fast money, again in the euphoria of “This time is different.” History argues otherwise.
Value investing is neither dead nor dying and survives as a superior strategy. We are comfortable acknowledging that quality and value endure across market cycles, whether bull, bear, or range-bound.
The Downside of Value in Bull Markets
The inherent risk to the quality value investing model is that near-sighted growth and income investors permeate the stock market.
Chasing the dragon named market bubbles has been a cornerstone of investing for Wall Street professionals and Main Street do-it-yourselfers since stock trading began. Human behavior dictates that it’s off to the races once we outsmart the market and predict this swing or that trend or go long or short just right on a company or sector. Convinced of figuring this thing out, we begin the hamster roll of predicting and trading unrestrained.
As validation, there are always reputable assists from outside market influences to our preoccupation with market trends. There was assistance from the Federal Reserve in keeping interest rates low until they didn’t. Before that, the hand-off came from government deregulation of the housing market, allowing widespread homeownership, fueling opportunistic investment banks to package the mortgages into marketable securities, and creating more risky mortgage dollars to lend to marginal home buyers.
Before the high-rated mortgages—despite no documentation and income—there was assistance from the capital markets of free-flowing investment into dot-com ideas that were just ideas. Before that, junk bonds contributed by financing previously impossible mergers and acquisitions. The market is the greatest threat to an investor’s capital. However, the market is also a friend to count on for delivering singular company or market-wide value opportunities. Dedicated quality value investors stay rational, self-disciplined, and patient without knowing when or how those opportunities will emerge.
Prepare for the imminent next downturn with dry powder in the form of FDIC-insured cash, or equivalent, to ride the ensuing upside in the stocks of excellent companies becoming value-priced by the sudden extreme preference for discomfort among the herd of market-timing investors. Rest assured, when market crashes occur, the speculators with blind faith in trend following, momentum trading, forward high-yield dividend investing, and the next trading fad yet to be determined will be running for the hills.
Downturns in the market that create value opportunities to initiate or add to targeted, enduring enterprises are our workdays. The ensuing upturns are our paydays. The proverbial days of reckoning are inevitable, although unpredictable.
Rational, quality-driven value investors never need to stress over failed short positions, diminishing fund assets under management from departing performance chasers, or useless self-doubt fueled by the 20/20 hindsight of missing out on the fast growers, high yielders, and Bitcoin when trending skyward.
Take comfort in knowing that quality and value prevail in the financial markets, just as in farmers’ markets.
Why the Trend is Rarely Our Friend
By definition, trend followers pass on the underfollowed player in an underappreciated industry.
Nonetheless, following the trend or practicing momentum investing is fleeting, favoring nearsighted, speculative trades that come and go with market cycles and fads. Common sense suggests that a slew of short-term momentum trades are required to make the same potential profits from just a few long-term investments in the publicly traded shares of wonderful companies purchased at reasonable prices. We bought winning long-term holdings at value prices because the traders sold them off during a negative trend.
Buy slices of businesses whose products or services are invariably in demand, yet their stocks trade at value prices because of temporary mispricing by the market.
Skeptical, nearsighted investors cite political grandstanding, trade wars, commodity pricing dilemmas, livestock supply issues, occasional product recalls, and other inconsequential grievances as justification for shortsighted momentum trades and trend following. On the contrary, being receptive to the compelling counters of an investment thesis is crucial. For example, when quality-driven value investors hear, “Stay away from car companies,” the stocks of fundamentally sound, enduring auto industry enterprises become a sudden and curious interest.
It is startling how the investment world, on the whole, believes the present market, whether bull, bear, or range-bound, is somehow different, ignoring that business and market cycles come and go at random. Having the newest and latest investment fads to rally around is the ill-conceived differentiator in each market cycle.
Take preference for the general perception of intrinsic value instead of explicit estimations. Be skeptical of specific price targets, earnings projections, and other attempts at precision from the sophisticated financial models of sellside and buyside analysts when attempting to determine the difference between the market price and the underlying value.
When reading, “XYZ is trading at a 40 percent discount to intrinsic value,” remember how Wall Street justifies enormous fees and bonuses with unnecessary speculative predictions. If these market pundits were often right rather than wrong, we’d become wealthy by following them. Before taking the prediction at face value, conduct independent due diligence.
Over-analysis or setting price targets gets retail investors—and even professionals—in trouble from timing trades. The analysis paralysis of publicly traded companies and the underlying stocks leads to extreme shorting or put options trades, as there is bad news in every security. Whether those projections will play out is anybody’s guess.
Become a reformed investor from lessons learned. Slow and steady quality-driven value investors know that stable companies often appreciate in the long run, as active traders moving in and out of positions in reaction to good and bad news get punished in the short run. We can follow populist stock trends to our portfolio’s potential peril or, instead, invest in great companies over long-term horizons and benefit from total return compounding with a comfortable margin of safety.
Rational, disciplined, and patient investors embrace quality and value.
Master the Fundamentals
Most professions or disciplines require the mastery of no more than 6 to 8 fundamentals for sustainable success.
Here are my preferred fundamentals for quality-driven stock market investing.
Stick to the facts by investing in a company’s current wealth and its stock’s present value.
Be skeptical of predictive analysis and business modeling overkill, as they generate fees more than alpha.
Act as a partial owner of people-driven businesses instead of a trader of faceless stocks.
Investing is that rare discipline where sitting on our butt is more profitable than being active.
Read often and write a journal of our investing journey, focusing on lessons learned.
Pay ourselves first by investing an agreed-upon discretionary portion of our household’s gross income in publicly traded businesses that are understood and admired.
Put health before wealth. No matter our means, if money can fix an issue in life, it’s not a problem. If money can’t fix it, then we have a problem.
Diversify or Concentrate?
Remember, portfolio diversification benefits the financial services industry more than the investor. Consider the alternative of concentrating.
Diversified portfolios inevitably consist of high-quality and poor-quality holdings that create fees more than generate alpha. Again, deep-dive predictive analysis and business-modeling overkill are the illusions of a fee-generating financial machine.
On the contrary, concentrated portfolios of predominantly dividend-paying, fundamentally solid holdings purchased at reasonable prices generate alpha more than create fees.
Remain loyal to the financial markets’ original, well-intended good deeds by taking an affordable partial interest in a publicly traded company and thus aligning with Wall Street’s more credible role in providing needed capital to fund worthy businesses.
Increase the chances of achieving stock market alpha by becoming a quality-driven value investor.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Author
David J. Waldron is the contributing editor of Quality Value Investing, and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, MSN Money, TalkMarkets, ValueWalk, Yahoo Finance, QAV—Australia’s #1 Value Investing Podcast, Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.
Resources
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