July 2023 Commentary

Think about your last big purchase. Whether a house, or car,
or boat, or television – your evaluation a successful purchase
was likely based on the highest quality item for the best price
you could negotiate. However, turned around, one could
actually argue that your first evaluation is likely the quality of
the item – without the quality, it likely has no value.
The book Quality Investing written by Lawrence Cunningham
alongside Torkell Eide and Patrick Hargreaves (of AKO Capital
fame) begins with the contention that, while the concept of
quality is quite familiar to people, the definition of quality is
challenging. They go on to further refer to a quote from Zen
and the Art of Motorcycle Maintenance that “…even though
Quality cannot be defined, you know what Quality is!”
Investors understand value investing. Buying something at
less than its intrinsic value helps us feel we’re in control and
getting a bargain, something more for your money. Ask any
professional what value investing means and, in all likelihood,
there will be a lot of consistency in the answers. Ask those
same professionals what quality investing means, and the
responses will likely be as diverse as the number of
professionals asked.

When we began Laurus almost ten years ago, we chose
“quality investing” as our core philosophy around small cap
investing. Not growth – which can also be easily defined – or
value, but the ineffable traits of fundamental quality that
investors have such a difficult time understanding. Which
makes growing our assets under management a little more
challenging.

So why in the world would we choose this style?
A quality approach to small cap investing seeks to identify
companies with outstanding financial and business
characteristics, including soft (e.g., competitive advantage or
management competence) and hard criteria (e.g., high
returns on capital or balance sheet health). Our goal is to
create a portfolio of what we believe are the highest-quality
businesses by following an in-depth research process.
The hard criteria we speak of – high returns on capital,
balance sheet health, strong historical growth – are easy to
identify. There are plenty of statistical tools that will screen
mountains of data. The more challenging part of analyzing
data is understanding the variety, and consistency, of inputs
to these financial outputs. Put another way, anyone can use
statistical screens to identify certain characteristics – the
question is whether these are opportunistic or sustainable.
If sustainable, the question of valuation is less prevalent. Yes,
the risk of overpayment does exist but mid to long-term
growth will eventually overcome entry level values. Priceearnings multiples on high quality companies may look high
relative to their growth rates, but there is a big difference
between expected and realized growth. Street analysts are
often wrong, and high-quality businesses frequently exceed
expectations. Some mispricing has to do with “shorttermism” – quality businesses thrive over the longer term, but
markets tend to over, or under, price on short term results.
And finally, investing in quality companies is an approach that
has enabled investors to earn strong risk-adjusted returns.
Over time, high-quality stocks tend to experience lower
volatility and greater strength and consistency in returns over
a full market cycle, including and perhaps especially, during
the downturns.

As we’ve mentioned in previous commentaries, there are
periods when high-quality businesses experience
underperformance relative to lower quality companies,
especially at the beginning of bull market cycles. Lowerquality companies tend to rebound more sharply from
recessions than the high-quality segment. This is largely due
to a greater reliance on credit, they gain more from improving
economic conditions and, particularly, from an improving
credit market. However, they also tend to experience more
dramatic declines during the bear market phase, setting up
more recovery potential.

Our readers know we believe strongly in the reasoning that
small cap investments are a strong foundation for a wellbalanced portfolio. To improve risk-adjusted returns in small
cap investing, the quality style is an important ballast against
volatility due to their financial stability and greater propensity
for growth across the full cycle of varying macroeconomic
environments.