Fall 2017 2

The Importance of Investing in Quality

by A. Scott White, CFP®, ChFC, CLU
President, Scott White Advisors

After the Dow Jones Industrial Average, also known as the Dow,1 closed on August 2, 2017 above 22,000 for the first time ever, some people asked me if the stock market had reached its peak for this year. While I saw many economic prognosticators the next day on the financial television news networks make proclamations in both directions, the intellectually honest answer is, “I haven’t the slightest idea.” Because even if we had the underlying thesis correct for either direction before year end, all it takes is an unexpected natural disaster, geopolitical event, or terrorist attack to take place and you can throw all the forecasts out the window. And that is not the basis for a sound investment strategy. That is the basis for speculation.

The inevitable answer, however, is the Dow is going higher. We just don’t know when. (But that’s not guaranteed, since I guess it’s possible the entire economic system could implode.) And that is why the basis for investing is developing a sound investment strategy as part of an overall comprehensive financial plan—to make sure money will be available when you need it regardless of whether the Dow is up or down. Therefore, I believe there are only two attributes that matter for any investment: price and quality. These two attributes may not matter much to a speculator, but for the long-term investor, I believe there is nothing more important in building a sound investment strategy. In this article I’ll discuss how price and quality matter in investing in equities (stocks of businesses); however, the same is true for bonds and real estate which might also make up a part of a sound investment strategy. And as far as price goes, all I will mention in this article is, if you think price doesn’t matter then remember Microsoft. Despite making billions of dollars in profits the past 17 years, if you bought stock in Microsoft on December 29, 1999 for $58.72 a share, you would have needed to wait until October 21, 2016 for the stock to close at a higher price.2 So yes, price matters.

Regarding quality, I believe that three attributes are critical to investing in stocks of publicly traded businesses. The first is to realize we are investing in highly successful businesses, not trading their stock. Or as I like to say, we are investing in businesses whose stock just happens to trade in stock markets; we are not betting on these markets to move in either direction. Most highly successful businesses are characterized as being very profitable. And not only are they profitable, but they operate in an industry where the company is a leader and it is difficult for competitors to replicate what they do. That said, it is possible to trade in the stock of unprofitable businesses and make money. Take Sears for example. Here is a company that has been losing huge amounts of money consistently in recent years.3 It is possible that if Sears somehow manages to survive, some speculators might make a lot of money trading in Sears stock today. On the other hand, if Sears does not survive, we all know what that would mean to its stock price, so why take that chance? I prefer to invest in some of the world’s most highly profitable businesses—and leave the speculation to others.

A second attribute to look for when deciding which businesses to invest in is: Does the business management team work on behalf of the shareholders, or is it trying to run the business to line their own pockets at the expense of shareholders? There are many ways to determine if a company is putting its shareholders’ needs first. Most boil down to determining if the company rewards management for maximizing company value or is it focused on trying to manage earnings and providing earnings guidance. Management teams that focus on earnings expectations are often trying to manipulate share price for their own benefit.4 I prefer management teams that focus on making strategic decisions that maximize the expected value of the business, even at the expense of lower near-term earnings, to create shareholder value. To ensure that our portfolio managers keep this principle first and foremost, I spend a lot of time discussing companies’ use of free cash flow with our portfolio managers. That is why I do not mandate portfolio managers only select businesses that pay a dividend to invest in. Dividend policy is up to the CEO of the business to manage in a way to maximize shareholder value. If we own stock in a highly profitable business that is growing its earnings faster than the stock market is growing, of course I’d want the management team to plow those earnings back into activities to continue its superior growth. On the other hand, I’d expect the company to return cash to shareholders in the form of dividends when there are no credible value-creating opportunities to invest in the business and earnings of the business are not growing at a faster rate than the stock market’s growth rate.

Finally, if you have a highly profitable company that puts shareholders’ needs first, we want to make sure the company has a solid balance sheet that does not have too much debt. This might be the most difficult principle for an investor to adhere to, particularly when stock markets are moving higher. Since the financial crisis of 2008, interest rates have been stuck close to zero. And when Wall Street bankers approach corporate CEOs about the possibility of using the bank’s money, instead of their own, to finance growth, it is tempting with such low rates. Often corporate leaders recognize it might be cheaper to use the bank’s money than their own revenues to finance technology updates, marketing, research and product development. This is often referred to as ‘leveraging up’. When those revenues are suddenly freed up from covering expenses, they often drop to the bottom line as corporate profits. And higher profits can lead to higher stock prices, particularly in rising markets. So it is easy for the average investor to give up on solid balance sheet businesses, whose stock price may not be rising as rapidly, and chase after companies ‘leveraging up’ their balance sheet. But when the next unexpected recession strikes, and the ‘leveraged up’ companies have difficulty paying the interest on their debt, many will disappear in a corporate takeover or go bankrupt. If an investor will stay away from these potentially ticking time bombs to start with, I believe your chances of having a portfolio designed to meet your long-term goals might be greatly enhanced.

So, whether the Dow goes higher or lower before the end of year might make for an interesting conversation for some people. But I do not believe the level of the Dow has anything to do with building a successful investment portfolio designed to meet your family’s unique goals and circumstances. To build an investment portfolio you need to focus on price and quality, with a diversified portfolio structured to provide cash for you to meet your goals outlined in a comprehensive financial plan. After all, those are really the only aspects an investor has any control over.

1 Individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.

2 Why Microsoft Stock Just Hit an All-time High by Dan Frommer, October 21, 2016.

3 Sears has ‘Substantial Doubt’ that it can Survive by Chris Isidore, @CNN Money, March 23, 2017.

4 Ten Ways to Create Shareholder Value by Alfred Rappaport, Harvard Business Review, September 2006.

The information contained in this report does not purport to be a complete description of the securities markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing materials are accurate and complete. Any opinions are those of Scott White Advisors and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date subject to change without notice. Past performance may not be indicative of future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Strategies discussed may not be suitable for all investors. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss.

Individual investor’s results will vary. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.