Why we’re wedded to quality
In this week’s video insight Roger asks if another leg lower in the market transpires, what should you invest in? High quality businesses, when the price-to-earnings are compressed, are bound to generate great returns in the future. In fact, the lower the price you pay for a high-quality business, the higher your return will be. But what is a high-quality business?
The stock markets have rallied convincingly since the June lows around the middle of June. The S&P 500, the NASDAQ, Dow Jones, and our own ASX 200 have all done a great job of giving people a lot of comfort and making them relaxed about the prospects for the future. All of this rally has really been on the back of the idea that inflation has peaked. And it may have, but it’s a long bow to draw to believe that inflation is immediately going to go back down to the U.S. Federal Reserve’s target of 2 per cent. What if inflation hovers around 4 or 5 per cent, or even 6 per cent? What if the Fed stops raising rates but doesn’t immediately cut? Both of these scenarios would be disappointing to a market that is prone to being very impatient.
If another leg lower transpires, what should you invest in? Well, like always, we’re wedded to quality. High quality businesses, when the price-to-earnings are compressed, are bound to generate great returns in the future. In fact, the lower the price you pay for a high quality business, the higher your return will be. But what is a high quality business? Well, quite simply, it’s a business that generates a high rate of return on incremental capital. In other words, a high rate of return on equity and additional equity, and a business that’s able to retain large amounts of its profits to reinvest at those high rates of return. Now, in order to be able to do this, the business has to have a competitive advantage of some description. Something that it does, or the way that it does it, that can’t easily be replicated.
An example of such a business that immediately comes to mind for me is REA Group (ASX:REA), the owner of realestate.com.au. It has the highest prices. It charges the most for you to list your house for sale. And yet, it has more houses for sale than any other website. What would be the scariest thing if you had a successful business? It’s probably a competitor starting up and charging a lower price. Well, in the case of REA Group, there must be something like 80 websites in Australia where you can list your house for sale, and most of them give you the opportunity to do it for free. That would be my worst nightmare, running a successful business, charging a high price, generating a high rate of return on equity, and along comes a competitor doing exactly the same thing that I’m doing but charging a lot less. Charging nothing, even.
Well, REA has been living in that world for many, many years, and yet it’s still able to raise its price and it’s still able to grow its revenue and profit. The most valuable competitive advantage of all, and that which generates high rates of return on equity and therefore determines quality. The most valuable competitive advantage of all is the ability to charge a higher price without a detrimental impact on unit sales volume. And that’s exactly what REA can do. There are a raft of businesses in Australia and overseas that our funds are investing in that have those characteristics. And as share prices fall, they become much more attractive, because they’ll generate higher returns.
I look forward to talking to you again soon. And hopefully, with lower prices ahead, we’ll be talking about those opportunities some more.
The Montgomery Funds owns shares in REA Group. This video was prepared 23 August 2022 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade REA Group you should seek financial advice.