Focus on quality stocks

Quality beats valuation: a real life example

When Warren Buffett began his investing journey, he embraced the "cigarette butt" strategy. He searched for cheap, undervalued, and often low-quality companies. This changed when Charlie Munger entered the picture. Munger guided Buffett to shift his focus from bargain-hunting to prioritizing quality companies. This transformation led Buffett to some of his most legendary returns, including investments in companies like Geico and Coca-Cola.

The takeaway: Quality often outweighs valuation.

While Buffett’s is undeniably an inspiration for all of us, let’s face it: we're not Warren Buffett. Most of us aren't operating from his unique position. But this lesson resonates for all of us, and we’d love to share a personal story where it became crystal clear once again.

It’s October 2022…

It’s October 2022, and I’m considering an investment in the semiconductor company Intel. At the time, Intel was trading at a P/E ratio of 8 but shows negative free cash flow due to substantial investments in R&D and operational expenses to stay competitive. The outlook isn’t particularly bright for this company given the intense competition and a technological lag, though they recently appointed a new CEO with promising plans and strong technical expertise.

With newly announced government support (thanks to the CHIPS Act), there seemed to be potential for a turnaround. Given such an attractive valuation, if Intel could maintain steady profits or surprise with some positive developments, it will be a great investment.

On the other side of the spectrum, we have TSMC. As the market leader in chip manufacturing, TSMC’s future looks bright. However, its valuation is around 60% higher, with a P/E of 13 and a P/free cash flow of about 22. Not that cheap right? 

Of course, looking back is easy. We can see how these investments turned out (excluding dividends):
TSMC: +190%
Intel: -5%

This is a typical case where you have to make a trade-off between a cheap valued crappy turnaround company or a high (or reasonable) valued quality company.

I’m glad I chose TSMC. Not only has it delivered me excellent returns so far (I still hold the shares), but it also spared me sleepless nights and the need for constant monitoring. With TSMC, I knew the fundamentals were solid. The foundry business has high entry barriers, TSMC has a substantial knowledge moat, and its customers like Apple and Nvidia face significant switching costs. No competitor comes close to TSMC.

Yet at the time, I hesitated between Intel and TSMC. I kept thinking: “Intel’s valuation is extremely attractive. Could this be a once-in-a-lifetime opportunity?” and “The market might be too pessimistic about Intel.”

Thankfully, I did make the right decision by investing in TSMC. It’s one of my best investment decisions in recent years, and to be honest I’m quite proud of it.

Looking back: what I learned

Yes, valuation matters, which is why I don’t make frequent investment decisions or buy shares often. Here’s how I approach it: “If a company lacks quality, I won’t invest, regardless of the valuation. But if a company shows quality, I’ll buy if the price is reasonable enough.”

That is basically for a large part my investment philosophy. How do I assess a company’s quality? By closely examining the business model, what sets it apart from competitors, and how strong and durable its moat is.

If a company meets these criteria, I look at management’s capital allocation decisions, their capability in running the enterprise, and the solidity of the balance sheet. If all the boxes are ticked, the final step is to consider valuation. 

When a company doesn't check all those boxes, I choose not to invest in it, no matter the valuation.

Another benefit of investing in high-quality companies is the frequency of positive surprises. Where low-quality companies might disappoint with missed guidance and profit warnings, quality companies often surpass investor expectations (e.g. Duolingo, Amazon and ASML).

Of course, I’m not advising you what you should do, and there are certainly some undervalued lower-quality companies worth considering. But in general:

“Investing in quality makes the future much more pleasant than opting for low quality companies”.

Please let us know which is currently your favorite quality company in the comments.

Happy investing.

Bouke Scholtens

The Dutch Investors