If you get nothing else from reading the articles on this site, you should pay attention to the strategy advocated by business scholar professor Robert Novy-Marx, whose philosophy can be summed up as follows: “Buying high quality assets without paying premium prices is just as much value investing as buying average quality assets at discount prices. Strategies that exploit the quality dimension of value are profitable on their own, and accounting for both dimensions of value by trading on combined quality and price signals yields dramatic performance improvements over traditional value strategies. Accounting for quality also yields significant performance improvements for investors trading momentum as well as value.”
You should his essay here, titled “The Quality Dimension Of Value Investing.” It’s a slight modification of growth at a reasonable price investing. The point of Novy-Marx’s research is this: companies that possess the highest quality assets are those that experience the highest increases in gross profitability (for those lacking the technology to measure gross profitability, top-line growth can serve as a decent proxy) for long periods of time.
The point is this: If you buy low-quality assets that contain so-so growth potential when they are trading at a discount, you experience the benefit when the stock moves from $20 to $30 (or whatever it takes for the company to come up to fair value), and after that, you’re left with a mediocre asset. And if you buy a high-quality stock at something like 50x earnings or more, so much of the company’s future growth has been factored into the stock price that even if the company grows quickly while you own it, the eventual decrease in the P/E ratio will take away the returns you would otherwise get by looking at the earnings per share growth rate of the company or something like that.
While the best spot for an investor is when he can buy superior businesses at discounts, those 2008-2009 type of circumstances only come along for three or four short periods of time in a typical investor’s life. Generally, only people like Charlie Munger who have significant productive investments already at work can afford to let cash positions build up for years on end, as he made clear in a recent Wall Street Journal interview when he said that he hasn’t made any stock investment in the past two years.
Novy-Marx’s theory provides a useful foundation for those looking to make investments in normal times: find companies with significant top-line growth that are trading at fair valuations, and focus your energy there.
That’s why Visa has been such a darling for those of you who have been following my writings for a while. The company doesn’t play games with its balance sheet to stimulate growth—the business itself earns such lucrative returns relative to investment that the company ends up becoming a must-have investment. Just look at its revenue figures since becoming publicly traded in 2008—the credit and debit company posted revenues of $8.08 per share in 2008, $9.12 in 2009, $9.64 in 2010, $11.30 in 2011, $12.85 in 2012, a sharp gain to $18.29 in 2013, and expected revenue per share around $20.00 in 2014. That’s exactly the kind of asset you want to own if you’re trying to build a fortune while employing a strategy of buy-and-hold investing.
There are other cool things I like about the company—it has no debt, preferred stock, pension obligations, has a low dividend payout ratio, funds its stock buyback program out of already existing profits, and so on—but at the heart of it, the appeal is this: the company experiences very significant growth while requiring relatively small capital investments to fund that growth. The brand equity is strong—we all know that the payment processing networks are dominated by Visa, Mastercard, Discover, and American Express, and the barriers to entry into the credit processing game are high. They provide extensive fraud and risk management, and use their large size and deep pockets to deter others from offering their own processing—even if you buy things with a click of a button instead of a card, you will still use a Visa network because individual companies won’t want to take on the potential liability for when things go wrong.
I’m working on an upcoming post on how investors should position themselves for rising interest rates, and the gist of the argument is this: low growth and high yield assets like energy MLPs may have trouble delivering exceptional returns, because the risk-free Treasury rate will become relatively more attractive. That’s why you’ll want to focus on companies with the highest growth rates—because an increasing earnings base acts as a countervailing force against bond rates that go from 3% to 5-6% (or whatever the final resting point may be for this upcoming business cycle). The Novy-Marx theory focuses on the relationship between top-line growth and fair valuations, based on the premise that top-line growth is a reliable indicator of a highly productive asset. For someone looking to take big strides in their net worth and dividend income in the coming decade, the answer seems to be that you want a portfolio stuffed with companies that share Visa’s characteristics.