A matter of quality control

Investors should be focusing on high-quality companies. Nothing else really matters.

PORTFOLIO POINT: Irrespective of your investment goals, focusing on high-quality companies should be the primary objective.

Recently I was shown a comparison of four ‘investment’ strategies that purported to demonstrate how smart investors have done well in stocks through the GFC.

While the mass exodus from stocks, as witnessed by fund manager outflows and corresponding increases in bank deposits and purchases of annuity products, suggests investors have indeed had a gutful of poor stockmarket returns, I thought it would be more than a little useful to look at the claim and respond.

The report I was shown compared the returns an investor would have received had they purchased Commonwealth Bank shares at the height of the market before the GFC and didn’t sell, to those of the investor who sold at the same time and remained in cash since.

An investor who invested $100,000 into CBA shares at $59.34 at the top of the market in December 2007 would have purchased 1685 shares. Those shares, at today’s price of $57.12, would today be worth $96,247. This is encouraging, notwithstanding the fact that the market value has previously declined to $40,558 when CBA shares traded at $24.07.

By owning CBA shares however, you also participate in the cash flow the business generates and that which is determined by the board to be distributed to the company’s owners. Indeed, $24,230.30 in dividends have been paid by CBA since.

Those dividends could be reinvested in more CBA shares or reinvested in the bank.

Reinvesting the dividends in CBA shares is now worth $125,493.

Had you sold your CBA shares at the top and invested your $100,000 in 90-day term deposits in December 2007, you would have, according to the analysis, $121,493 at September 30.

The third scenario is arguably a very common one, and that is the scenario that involves selling CBA shares at the lows of the 2008 market crash out of fear and crystalising a loss of $20,237 and parking the remaining funds in 90-day term deposits. This scenario produces a September 30, 2012 value of $95,805.

The final scenario is that of the Australian super fund, mimicking scenario one and benefitting from franking credits. According to the analysis, your $100,000 at the peak of the boom would now be worth $143,444. The note points out that the return is twice that of the term deposit scenario.

I delight in this kind of analysis because it demonstrates the very real consequences of acting with emotion. Very few investors have a strategy that they can apply with consistency. I care, more than anything else, about ensuring I have a highly replicable and repeatable process.

But the analysis lacks something. Clearly it only works if the stock selected for the comparison has a substantial rally after its fall. The fall allows the dividends to be reinvested at a low price and the subsequent recovery of the share price ensures that not only are the original shares restored to previous values, but additional shares, purchased at lower prices, add to the balance.

There is nothing remarkable about this. What would be remarkable is an ability to identify the companies that are most likely to do this.

Last year Cochlear had a fall from grace when it announced a global recall of its hearing device. The shares slumped from the mid 60s to the low 40s, and while analysts wrote of permanently damaged reputations, we accumulated a material position for our investors. The shares are now trading at more than $70 and like the CBA example above, the returns are even higher with the reinvestment of dividends.

What is common to CBA and Cochlear however (no, its not that they both begin with the letter ‘C’) is they are very high-quality companies. Had you selected BHP, Fortescue, Lend Lease, Leightons or Qantas for the above example, the genius in the room would have been the fearful cash investor.

And this brings me to an important point I’d like you consider carefully. Time is the friend of the extraordinary business, however it is the enemy of the business with poor economics.

Irrespective of whether you want income, yield, capital growth, short-term or long-term gains, there is really only one thing to focus on; high-quality companies. The above analysis looks great simply because a high-quality company was selected for the comparison.

Here’s a list of Australia’s top 20 companies by market capitalisation with their latest quality ratings. Speak to your advisor if you have any concerns.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.

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