الرئيسية Only the Best Will Do: The compelling case for investing in quality growth businesses

Only the Best Will Do: The compelling case for investing in quality growth businesses

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		Only the Best Will Do

		The compelling case for investing in quality growth businesses

		Peter Seilern

		This book is gratefully dedicated to my partners, past and present.


		 			Foreword by Jonathan Davis

		 			Introduction: A Superior Way to Invest

		 			Part I: Why

		 			Chapter 1: Higher Returns and Lower Risk

		 			Chapter 2: The Bigger Picture

		 			Part II: How

		 			Chapter 3: The Ten Golden Rules

		 			Chapter 4: Building a Portfolio

		 			Chapter 5: The Art of Valuation

		 			Part III: When and Where

		 			Chapter 6: Quality Growth in Context

		 			Chapter 7: Financial Markets Today

		 			Chapter 8: Conclusion

		 			Publishing details


		by Jonathan Davis

		Warren Buffett, who knows a thing or two about stock market investing, describes a moment of epiphany when after years as a Benjamin-Graham-style value investor he finally came to appreciate that it is better to pay a fair price for an outstanding business than an excellent price for a poor or mediocre one. He attributed this insight to his longstanding friend and business colleague Charlie Munger, although he has also referenced a number of other influential investors, such as John Maynard Keynes and Philip Fisher, in support of that idea.

		Yet there is something deeply entrenched in human nature that seems to militate against more investors pursuing a strategy which experience directs has so many positives – and so few negatives – going for it. How strange is it, after all, to believe that it might be a mistake to invest in something other than the best? Nobody with a long-term perspective and the freedom to choose would knowingly set out to pick a work of art, a case of wine, or (dare one suggest?) a spouse on any other basis.

		It is to the credit of my friend Peter Seilern that, from his earliest days in the investment business, he has never doubted the wisdom of investing exclusively in high-quality growth companies which not only pass a demand; ing set of financial criteria, but crucially also offer the investor a high degree of confidence that they will go on doing so for many years into the future. The potential longevity of a quality growth company’s ability to go on making high returns on capital is the key insight that makes it in reality a low, not a high, risk investment.

		It is an article of faith for Peter, bordering on zealotry, that for every kind of investor avoiding a permanent loss of capital is every bit as important as maximising investment returns. Constructing a portfolio of what he calls quality growth stocks is the only true way to minimise the risk of losses while simultaneously maintaining a high probability of above average long-term returns. This is not, in general, the approach of the great majority of investors, both private and professional, for whom the pursuit of uncertain larger gains today frequently trumps the security of more reliable returns tomorrow.

		In Keynes’ immortal words, few stock market investors are immune from the gambling instinct and as a result “must pay to that propensity the appropriate toll”. Well, maybe it is more than a few who have a more enlightened view today, as evidenced by the increasing amount of money which flows every week into passively managed index funds, the epitome of dullness, but instruments, suitably priced, whose main attraction is that they offer nothing but reliable second quartile performance over time.

		Yet why settle for second best when you can still go one better? That is the challenge which Peter throws out to all of us in this important and timely addition to the canon of readable and authoritative investment literature. For him, the best really does mean the best. The universe of investable businesses which pass his demanding criteria (the ten golden rules he describes in chapter 3) numbers just a tiny fraction of more than 50,000 companies whose shares are listed on leading public stock exchanges around the world.

		All are well-known names with long histories and deep and liquid markets for their shares. There is nothing to stop anyone with money to invest from owning them. If you had done so at almost any point over the past 30 years, the risk-adjusted returns you would have witnessed by now would have convincingly thumped the performance of both index funds and all but a handful of professionally managed funds. Quality growth companies, you would think, are an ideal match for pension funds and any institutional investor with real long-dated liabilities. Yet regulators and actuaries, unable to distinguish one equity from another, blindly refuse to think so.

		The track record of the funds managed by Peter’s own investment management firm, Seilern Investment Management, bears testimony to the success of his approach. His fund with the longest continuous track record has outperformed the MSCI World index by approximately 2.25% per annum, compounded over 23 years, sufficient to grow an initial portfolio of 10,000 Swiss Francs into a sum more than six times that amount. This is despite the period encompassing two of the most severe bear markets in living memory (2000–03 and 2007–09). The comparable sum that would have been generated by the world index is 3.75 times the original investment. The past ten years have been particularly rewarding for his methods, with annualised returns of more than 13% per annum.

		Seilern World Growth vs MSCI World

		Source: Seilern Investment Management, Bloomberg

		Yet the funds have also been less volatile than the market as a whole, and if that is your favoured measure of risk (which it should not be, of course – risk is a richer and more complex concept than that) then you should be doubly happy. In practice, even the best companies can sometimes become too expensive to justify ownership. Sometimes, too, they lose their mojo through some combination of management incompetence, complacency and the arrival of vigorously disruptive newcomers with a technological or some other form of competitive edge. That is capitalism for you.

		So you still have to be selective and on the ball. It is only the cream of the crop that eventually make it into Peter’s funds. If and when a company passes his rigorous quality growth tests, his average holding period is ten years or more. Unlike most of his peers, instead of looking ceaselessly for the next big thing, the analysts at Seilern Investment Management spend the majority of their time drilling ever deeper into the operations and accounts of the companies they do own in order to be sure that their competitive strengths are not being eroded, competed away or disguised from view. If the price of freedom is eternal vigilance, the same is true of investing in quality growth companies.


		I can vouch for the fact that Peter’s principles, which he outlines and justifies in this book, have not altered a jot in the two decades that I have known him. It is, in fact, 30 years since this modest, largely unsung exemplar of what a fund manager should be first set up a small office in London to pursue his ambition of turning his insights into a sustainable investment management business. Today his firm has some $1.5 billion under management, but the road to commercial success has not always been linear. Not for him the easy road of many fund management firms, prioritising asset accumulation over sustained performance and the client’s best interest.

		Personal and professional modesty should not be mistaken for the absence of deeply held convictions. Peter has strong views not only about the inherent superiority of his quality growth investment approach, but also about many of the theories and assumptions to which finance academics and the majority of professional investors hold dear. Some of his strictures are laid out in the pages that follow. He remains a passionate advocate of European integration, for reasons which, as with his aversion to unnecessary risk, I suspect are strongly rooted in his Austrian family background.

		Now it is fair to say that the macroeconomic conditions of the period since the global financial crisis have been favourable to the kind of companies which Peter loves to own. Ultra-low interest rates, slow economic growth and the overhang of debt have all contributed to an environment in which quality growth companies have been driven up to high and demanding valuations by historical standards.

		Some market analysts believe that it is only a matter of time before these valuations are reversed. Others talk dismissively of ‘bond proxies’, conveniently ignoring the ability of the very best companies to go on growing their cash flows in real terms, a most unbondlike characteristic.

		Peter argues convincingly that these critics are both wrong and missing the point. As well as being a manual on how to choose exceptional stocks, the next 180 pages will explain why he takes that view. I urge you to read on and make up your own mind. If you are not already persuaded about the merits of quality growth investing, by the time you finish reading this book it could be your moment of epiphany as an investor too.

Jonathan Davis


		Oxford, August 2019


		A Superior Way to Invest

		Investing is both a science and an art. Doing as well as the markets these days is more the former than the latter, with the task often performed by a computer. Every investor is now routinely measured against the performance of a comparable index, and computer-managed index funds and ETFs match most benchmarks silently, cost-effectively and with near-perfect efficiency.

		Doing better than the common run, however, still requires more art than science – and necessitates the application of the human mind and a specific kind of temperament in order to be successful. Quality growth investing, the approach that I describe in this book, is the most reliable and effective strategy yet devised by man for achieving above-average returns with minimal risk of the permanent loss of capital.

		As such, in my view, it represents as close to a holy grail in the investment business as there is. The case for quality growth investing is rooted in a potent combination of sound theory, empirical validation and that often elusive condition known as common sense. Yet, surprisingly, despite the mountain of empirical evidence that it works, this style of investment is practised by only a small minority of professional investors.

		In this book I set out to explain in simple language what quality growth investment is, why it produces such consistently good results, how best it can be implemented, and why the conventional thinking that governs much of modern investment practice is badly flawed. There appear to be many reasons why more investors don’t pursue the approach that I advocate. Partly it is the result of poor reasoning, but partly also it reflects the many commercial and behavioural factors which govern the way that the investment business operates and is regulated in practice.

		Nowhere is the need for investors to embrace the attractions of quality growth investing more acute than in the field of pension fund investment. Providing the means for people to live comfortably in retirement is one of the biggest global challenges facing the developed world in the 21st century. Although well known to policymakers, too many people remain unaware of the growing gap between the financial benefits that the pensioners of tomorrow will need (and have been promised) and the assets which are there to meet those growing liabilities.

		As well as being a prudent and rewarding choice for individual investors, quality growth investing, I believe, is perfectly suited to helping resolve this looming pension deficit crisis in the developed world. Yet thanks to misplaced notions about the true meaning of risk, which are hardwired into the thinking of regulators and the actuarial profession, as well as other softer behaviourial factors, pension fund sponsors and fund managers are actively discouraged from adopting the strategy. This urgently needs to change.

		Making the case for a quality growth approach requires me to puncture some other potent myths in prevailing conventional wisdom about investment. These include the myth of diversification; why there is no such thing as a share for widows and orphans; why obsession with dividends is misplaced; and how capital appreciation can still be secured when interest rates hover, as they do today, in a twilight zone between barely positive and slightly negative. I also challenge the fundamental assumption, widely held in academia and the media, that superior returns necessarily demand higher risk.

		The book is structured as follows. Part I sets out the case for quality growth investing as an investment strategy. It covers the reasons why quality growth investing, as defined, holds out the prospect of both superior returns and below-average risk. I also discuss how the investor’s strategy will be affected by external events in politics, monetary policy and the fixed income markets. Part II explains in detail how to find the small number of companies which meet all the necessary criteria to qualify as a quality growth business. After listing the ten golden rules which govern how to make that choice, the next chapter focuses on how the companies, once identified, can be incorporated into a portfolio and how they should be valued. Part III, the final section, discusses how quality growth investing stands up against other approaches and offers some thoughts on prevailing market conditions and the difficult issues confronting investors of all kinds in a world of very low interest rates, rapid technological change and growing political polarisation.

		I accept that there will be many investors, both professional and individual, for whom adopting the quality growth approach will not be easy, whether for regulatory, cultural or other reasons. I can only urge them to consider the evidence. Having pursued this approach for 30 years in my privately owned investment management firm, I am happy to report that the results to date have been highly satisfactory for clients. While my original introduction to quality growth investment owed something to chance and a little bit to experience and intuition, as I explain below, both the detailed research that my firm has carried out since those early days and the results which our funds have been able to obtain over three decades have only deepened my conviction that the strategy deserves a much wider application.

Personal background

		My belief in the merits of quality growth investing was spawned relatively early on in my career in the financial services industry and has only intensified with every passing year since. It began on 1 October 1973, when I joined the leading Austrian bank in Vienna, Creditanstalt-Bankverein, as a junior clerk. That was the day that OPEC quadrupled the price of a barrel of oil. This event caused rampant inflation for many years to come and was the cause of a brutal bear market in stocks that was to last until 1981. During these difficult years I embarked on a fully-fledged banking training course, working in the main areas of banking: domestic loans, interbank operations, export credits, securities trading, and so on.

		I did not immediately realise back then how crucially and beneficially that training would influence my thinking. A grounding in banking during such a time of crisis helped me piece together the complex component parts of financial markets and enlightened me in assessing how risk can best be avoided without prejudicing the prospects of enhancing the value of capital. Investing only in the highest quality growth companies seemed to me, even then, the most certain way to achieve that second objective.

		In 1978 I was offered a job by Hambros Bank Ltd to help build its business with German-speaking countries on the continent of Europe. Before joining the bank, however, I spent one year with the prestigious German private bank, Sal. Oppenheim jr. & Cie. later acquired by Deutsche Bank. I commuted between Frankfurt and Cologne, to prepare for the assignment offered by Hambros. During this year, I concentrated on stock and bond markets, spending time with the German bank’s financial analysts, who were considered among the best in the country. I was also dispatched to the floor of the Frankfurt stock exchange which, in those days of open outcry, was a busy place with much noise and activity.

		During these years in Vienna and Frankfurt, I was greatly attracted to stock markets and eager to develop my career in that field. However, neither of the two markets compared with the depth of the London stock market, so I determined to pursue my career in the world’s number one financial centre. After joining Hambros Bank in 1979, I was initially asked to help develop their interbank business before achieving my ambition of moving into the investment management department.

		In 1981, the long bull market in equities began across Europe and shortly thereafter I was appointed fund manager for the bank’s new European unit trust. Many investment restrictions across Europe were lifted as capital controls were dismantled in advance of the creation of the European Economic Community’s Single Market. In the City of London around that time, SG Warburg spun out its investment management service, placing it under a new mantle called Mercury Asset Management and listed it on the London Stock Exchange. This was a clever move which, I hoped, would be replicated by Hambros.

		1986 was a momentous year for the London financial markets. It was the year of Margaret Thatcher’s Financial Services Act, also known as Big Bang, which revolutionised the London stockbroking scene, abolished the dual capacity functions of broking and market-making and opened the door to US financial corporations. In 1986 I was approached by the privately-owned Swiss investment management firm of Notz, Stucki & Cie. and asked to join their small London office with the idea of developing an in-house research capability.

		The surge in investment activity around that time in Europe and beyond produced a wave of hitherto largely unknown portfolio management styles. I spent time in Geneva, where my employers were based. They were important players in the relatively new world of hedge funds and had access to many investment managers on Wall Street. Outside the hedge fund space, their main contacts were with W.P. Stewart & Co. which was, at the time, the epitome of an investment house which favoured what I now call a quality growth approach.

		My deepening ties with this firm helped cement my early conviction that investment in the world’s best concerns, chosen on the basis of hard rules, was the most reliable way to preserve and enhance capital. The key insight was to concentrate on the businesses rather than on their quoted share price. Only by knowing inside out the companies in which client monies were invested was it possible to make a judgment on the sustainability of their returns. Risk could best be mitigated if clear guidelines were followed and the temptation of quick profits through short-term buying and selling of stocks avoided. This strengthened my intuition that far from high returns requiring high risk, the contrary could be the case.

		By 1989, so certain had I become that this was the right strategy that I came to realise that the most sensible option was to found my own investment management business and build it in my own way, from scratch. I returned to London after three years in Geneva and began assembling the pieces of the puzzle. I was alone, initially, and the main challenges were not only to assemble a universe of suitable investment opportunities but, further, to find equally-minded partners as well as clients. Luck was also required, as I soon found out. I knew it would take many years to fulfil all my ambitions, and despite mistakes, bear markets and other challenges since, I have never regretted anything.

		After 30 years and many bull and bear markets, my conviction of the attractions of quality growth investing remains firmly intact. This conviction rests on the long record of success inherent in the philosophy and its long-term time horizon. However difficult it is to invest for the long term and to separate the noise from the signal, it is a strategy that works – and if it ain’t broke, as they say, don’t fix it.

Peter Seilern

		London, August 2019

		Note: All statistical data and graphs in this book have been provided by Seilern Investment Management Ltd, Bloomberg and Factset. The references to individual shares in this book are provided purely as examples of principles. They are not investment recommendations and in the fullness of time they will become out of date as practical guides.

		Part I: Why

Chapter 1:

		Higher Returns and Lower Risk

		Why is a strategy based on finding and holding a portfolio of quality growth businesses so attractive? As with any investment strategy, it ultimately comes down to balancing the two central elements of risk and return. Although the two are conventionally said to rise and fall in tandem, in reality it is not as straightforward as saying that more of one necessarily means more of the other. If it is possible to have an investment strategy which offers greater returns with below-average risk, any sensible investor, once aware of the possibility, would be foolish not to consider it. That in a nutshell is the happy combination which quality growth investing promises – and consistently delivers – to the investor.

		Experience suggests that in practice most investors lack clarity about the need for a clear and considered strategy and are confused by the true meaning of risk. That is one reason why the returns they achieve are often disappointing. This includes professional as well as private investors. As is well-known, on average between 60 and 80% of professionally managed funds fail to beat an equivalent index fund or benchmark after accounting for fees.

		The successful investor must make strenuous efforts to avoid the pitfalls of the majority. The investor needs to define what he wants, the time horizon over which he is willing to achieve it and the amount of risk he is prepared to take to get there. The more patient he is willing to be, the greater his chances of achieving success.¹ When it comes to implementation, it is important that the strategy is capable of being implemented in a deliberate and dispassionate manner, free from emotional distractions.

		Quality growth businesses, as we define them, are not normally regarded as a distinct asset class, but that is how in my view they should be seen, because they have a unique and distinctive set of characteristics. Most investors, if asked to name the most important asset classes in financial markets, will list public equities, private equity, bonds and other fixed income securities, currencies, commodities, real estate and collectibles such as works of art, classic cars and wine. Sub-classes such as corporate bonds, hedge funds and derivatives, to name the obvious ones, exist within each class.

		The distinctive mantra of the quality growth investor is that only the best is good enough. His definition of quality and growth is detailed and specific. It means narrowing the field of potential investments to shares in a relatively small number of well-established and publicly listed businesses which possess a number of precise and positive characteristics. These characteristics include strong balance sheets, high returns on invested capital, market leadership in a growing industry, a sustainable competitive advantage and committed shareholder-friendly managements. (The ten most important criteria are described in more detail in chapter 3.) It is not enough to satisfy some of these tests: a true quality growth stock has to meet them all.

		This makes those companies that pass muster an exclusive club. Out of 50,000 companies which are currently listed on leading stock markets, there are no more than around 60 which at any one time meet all the criteria that a rigorous quality growth investor such as my firm demands. These companies really are the crème de la crème. Their greatest strength is not just that they are well managed and profitable, but that, given sensible management, their profitability will also be consistent and durable. For the patient, long-term investor, they are the gift that keeps on giving. Few if any other asset classes offer quite such a powerful combination of positive attributes.

		Just as important is that, contrary to conventional wisdom, a portfolio made up of this kind of investment will be inherently less risky than other types of investment, such as bank deposits and government bonds, which are traditionally thought to be at the lower end of the risk spectrum. To believe this does, however, require a willingness to think about risk and return in a different way to that presented in academic textbooks and in business school lecture rooms. In this chapter I consider both return and risk in turn.

Consistent returns

		The guiding principle of investing in any business is that the value of its equity will ultimately be determined by the development of its profits over time. The gains that can be made by investors are driven by the growth in its sales and cash flows and by the return it can achieve on its invested capital. It follows that companies which can demonstrate exceptional quality on those measures must also in time deliver an above-average return to investors.

		The empirical evidence confirms that this is indeed what happens. In the short term anything can happen in stock markets, of course, as prices bob around on a sea of sentiment and speculation, but the long-term pattern is clear. Companies with high returns on capital and consistent profitability, if purchased at sensible prices, are more rewarding as investments than companies with lower returns. They also produce higher returns than the stock market as a whole.

		There is plenty of data to support this claim. A study by the American investment firm GMO, published in 2018, found that over the 90 years between 1928 and 2018 companies that scored highest for quality on a range of accounting measures produced on average a 0.4% higher return than the American stock market as a whole.² If you added some strict valuation criteria on top – meaning refusing to pay silly prices for the best stocks – the advantage from investing in quality companies improved to 1.4% per annum.

		On a first hearing 1.4% per annum may not sound a lot, but that is before one takes into account the wonders of compounding, the mathematical phenomenon which serves to turn even small percentage gains into big numbers over long periods. Simple calculations show that an investment portfolio which has a performance edge over the market of 1.4% per annum will be 10% more valuable after eight years and almost 50% more valuable after 30 years.³ In absolute terms, because of the wonders of compounding, the final value of a portfolio with these characteristics will be worth many thousands or even millions more than it would otherwise be, depending on the starting capital of the investor.

		My experience in managing portfolios of high-quality growth companies also bears out the GMO study. Clients who invested 23 years ago in the Seilern World Growth fund that my firm manages have seen their money grow in value more than 523%, or 8.1% per annum, compounded. The fund has handsomely outperformed the MSCI World index by 247%, or 2.3% per annum, compounded over those two decades. The unit price of the same fund has grown 3.5 times in the past ten years alone, a compound rate of 13.2%, ranking it third in the universe of UK-registered global equity funds. (It is not an accident that the funds which rank in first and second place also manage money in a similar quality growth style.)

		It is fair to make the point that the criteria which GMO uses to determine the highest quality companies, while similar, are not identical to the ones I describe in this book. In fact, our process is more demanding than theirs. Their survey merely took the one third of companies in the S&P index which scored highest on their quality measures. We insist on a tougher set of standards, and rather than taking a percentile of the top performers, make it an absolute requirement that they are all met. Our universe is therefore smaller, but the average quality of the companies in our universe is higher than those in GMO’s sample.

		One would therefore expect that the margin of superiority in returns could also be greater, as indeed it proves to be. The table below summarises the potential impact of the higher growth rates that the quality growth companies in our universe enjoy, taking for this purpose return on invested capital (ROIC) as a proxy for the ten quality growth criteria we demand. The average return on capital for the 60 companies that qualify to be included in our universe today is 20% per annum. This compares to 11% per annum for the 500 companies that make up the S&P 500 index, the main US market index. (Note: this is the average profitability of the universe from which we choose our stocks, not the 25–30 companies which actually go to make up the current portfolio.)

		It is important to note that the 9% per annum differential in the return on invested capital is not the only factor driving the superior return to shareholders. The payout ratio – the proportion of profits which are reinvested into the business each year – is also a significant factor. The power of quality growth companies stems not just from their high rates of return, but the ability to continue reinvesting their earnings at the same high rates of return. The average payout ratio of companies in our quality growth universe is 45%. For the S&P 500 index, the average payout ratio is nearly double that, at 79%. This helps to explain why at the start of any given period quality growth companies will have a lower dividend yield than the market, but consistently produce higher total returns over time.

		Other important aspects of this analysis are presented in the next section, but the simple point to make here is that the higher return which the investor can reliably expect from a portfolio of quality growth stocks is ultimately driven by the demonstrable fact that they are making significantly more money and using capital much more efficiently than other companies. They are compounding machines and in due course both theory and experience tell us that such earnings power must and will translate into strong investment returns.

			 				 				 				 			 			 				 				 Seilern Universe 				 S&P 500 index

			 				 Return on invested capital, 2018 				 20.0% 				 11.4%

			 				 Payout ratio, 2018 				 45% 				 79%

			 				 Dividend yield, 2018 				 1.4% 				 2.1%

			 				 Total return per annum, 2008–18 				 14.5% 				 12.8%

		Source: Seilern Investment Management

		It is true that the price that investors have to pay to buy these stocks at any one time can vary enormously: sometimes they will look expensive and sometimes cheap. In the short term the relationship between the return on capital achieved by the company and the return on investment obtained by the shareholder will not be linear. The actual investment returns this kind of stock will deliver over any given period will be determined by the price paid on purchase and the price at the subsequent point of valuation. A disciplined approach to buying and selling is an essential part of the quality growth investor’s process. Even with outstanding companies, nobody wants to pay over the odds or sell them too cheaply.

		Nevertheless it is an observable fact that over time the return an investor makes from quality growth stocks slowly but surely converges on the compounding rate of growth in their profitability. The longer you own them, in other words, the less important the price originally paid for them becomes. If a company can generate a return on invested capital of 15% per annum over two decades, through both good times and bad, it is a reasonable assumption that the investor’s return will be close to 15% per annum as well. And so it proves.

		Earnings growth vs share price appreciation

		Source: Seilern Investment Management, Bloomberg, Factset

		The Seilern Universe earnings growth index has been calculated as the median annual earnings growth rate of the Seilern Universe of quality growth stocks.

		That is one reason why quality growth investors need (and prefer) to be patient long-term investors rather than traders or speculators. Quality growth investors do not attempt to make money quickly. They do not search for shares that will double in value in a month or in a year. Their objective is to preserve and grow their invested capital over a period of years. While share prices will rise and fall in value from one period to the next, the best quality growth businesses, like Ol’ Man River, just “keep rolling along”.

		It is the powerful combination of higher long-term returns and the confidence that they will be achieved which makes quality growth investing such an effective and reliable strategy. It is also what marks out the quality growth approach from that of many investors, for whom the be all and end all is the change in the share price, not the underlying performance of the business. As John Maynard Keynes, the economist and investor, pointed out many years ago, the former type of investor hopes to make money from the fundamental attributes of his investment. Those whose only interest is the current share price know or care little about what the business does and are better thought of as speculators, a very different animal.

The second leg – risk

		If the first leg on which the case for quality growth investment rests is the certainty that exceptional companies will produce exceptional investment returns over time, the second is the realisation that these returns can be achieved with a below-average degree of risk. Risk in investment is a complicated subject, but not one that is too difficult to understand in this context. The great advantage of the quality growth approach is that the fundamental strengths of the business the investor owns act as a powerful bulwark against the risk of a permanent loss of capital. It is important to explain what this definition of risk means and why it is so fundamental to investment success.

		The average investor tends to see risk in terms of what happens to the value of his investments from day to day, or week to week. In academia, similarly, the favoured measure of risk is the volatility, or variability, of the price action that is observed every time a share or other type of investment changes hands. Newspaper and television headlines echo and sustain this idea by focusing on how many billions have been ‘wiped off’ the value of the stock market every time it experiences a daily fall (although rises in share prices, it has to be noted, are rarely accorded the equivalent treatment). The underlying assumption is that the more a share price jumps around, the riskier it is deemed to be.

		Yet this whole concept of risk is both misleading and highly dangerous. There is no doubt that if an investor needs to buy or sell an investment on a particular day, the current price will be of great importance. It will be inconvenient if the price is moving up or down by a notable percentage every day. Yet, in practice, for most investors (as opposed to traders) such occasions are rare, and for the most part voluntary rather than enforced. Everyone who has direct experience of how financial markets operate soon learns that short-term variations in price can have many causes, but more often than not these factors turn out to be either transitory or irrational, and almost always irrelevant for the fortunes of the type of business that a quality growth investor owns.

		As we have seen, what matters more in determining the success of an investment over time is how well the fundamentals of a business – its profits, cash flow and balance sheet – are progressing. In the famous saying of legendary value investor Benjamin Graham, in the short run the stock market is a voting machine, with share prices determined by what the majority of investors currently think, but in the long run it is a weighing machine, in which fundamentals become the primary determinant of how share prices behave. The corollary is that the biggest risk an investor with a long-term perspective faces is not whether the price of his shares is marked up or down tomorrow, but whether the fundamentals of the company are improving or deteriorating this year, next and the one beyond.

		If these fundamentals are deteriorating, and management is incapable of rectifying the situation, then the investor will undoubtedly be exposed to the risk of a permanent loss of capital. When thinking about risk, it is far more important for the investor to be protected against losing money irrevocably than it is to worry whether the price of what he owns is up or down from one day to the next. That is why using volatility as the measure of risk is so flawed. To be sure, it is a measure of a certain kind of risk, but the risk is a relatively trivial one, is frequently irrelevant, and says nothing about the risk that matters far more – which is whether the investor’s capital is under threat.

		As it happens, the share prices of quality growth companies do tend to be less volatile than those of the average stock market company, but that is not the main reason they are fundamentally less risky investments. Another study by GMO, carried out in 2012, shows that while quality companies produce higher returns than the average over time, the difference is actually most marked during bear markets, periods when share prices generally are falling. Bear markets don’t come round very often but when they do they can be very damaging to wealth. There have been two occasions in the past 20 years alone (2000–02 and 2007–09) when stock markets have fallen, peak to trough, by at least 50% over a relatively condensed period of time.

		It is in these periods that the risk of irrecoverable loss can become very real. Poor and mediocre companies go to the wall, with those that have geared up their balance sheets with too much debt well to the fore. Few investors are spared from seeing the value of their portfolios decline. Anyone who owns a bankrupt company or is forced to sell a share to raise cash will experience a permanent loss of capital. Quality growth investors are not immune from the market’s decline. The difference, however, is that the impact will generally be much less severe, as the companies in the portfolio will still, thanks to their strong fundamentals, be making money. They certainly won’t be at risk of going bust, and any loss of capital will be in the form of a temporary paper loss, rather than permanent damage.

		According to the GMO study, during bear markets the share price performance of quality companies is on average 3–5% per annum better than the overall market. As negative returns compound just as surely as positive ones, it follows that the markdowns which quality growth investors experience during bear markets are considerably less marked than those of the market as a whole. When a bear market ends, which typically happens within 18 months to two years, the quality growth investor – even if he has taken no precautionary steps to moderate the fall – will therefore be much better placed to enjoy the fruits of the period of expansion that follows. His capital will have survived the market disruption intact.⁴

		The common-sense question that the investor should ask himself is: when times are bad, what kind of investments would he prefer to hold – shares in a high-quality growth business which has been around for years, is consistently profitable and free of debt, or shares in one which has borrowed heavily in the past to juice up its returns, will plunge into losses when the economy slows, and will have to spend weeks locked in a dark room with its bankers to avoid going bust? For anyone who is concerned to preserve his capital, the answer should be obvious. Other riskier businesses may rise more in value during the good times, but investors in genuinely high-quality growth companies know that their capital will always be preserved and they will live to fight another day.

		To quote the conclusions of the GMO study: “Companies with exceptional profitability do not go bankrupt. Companies with exceptional profitability generate exceptional returns. Likewise those with low profits will fare poorly. This holds true not only at the company level, but at the market level as well. Profits ultimately drive returns. This argues strongly for a risk and investing framework focused on the survivability of corporate profits under any scenario.” That is the quality growth investor’s core belief.

Broader risk factors

		The greatest risk of loss of capital, one might observe from experience, often lies in the behaviour of its owner. In good times, he has to resist the impulse to take profits for the sake of profits. An old saying in the City of London has it that ‘a profit is a profit is a profit’. That is not how the quality growth investor should think about it. He knows that time is on his side. He has the best runners in the field and should sit back and wait for their superior class to come through.

		Many investors, however, are addicted to activity. No important announcement or event passes without them wanting to make an adjustment to their portfolio. They make a new shopping list following a budget speech; they prepare to trade after a change in interest rates; they feel the need to react to an election result. This is nearly always an unnecessary waste of their time and money. It is also what helps to create short-term volatility in stock markets.

		As noted already, equating share price volatility with risk is a mistake, but one that is easily made if the investor is prone to react emotionally to day-to-day changes in the value of his portfolio. The more nervous investors there are, the bigger the potential volatility that ensues, as falls in share prices are accentuated by panic and trend-followers. The same goes in reverse: rising share prices also encourage trend followers, as well as those of a greedy or excitable temperament, creating markets that then overshoot on the upside. The essential point is that in any such periods, it is not the business which causes the volatility, but rather what is in the mind of the worried or exuberant investor. It is a triumph of emotion over reason.

		Unfortunately, indiscriminate chopping and changing of this kind gnaws into the value of a portfolio and increases the risk of permanent loss of capital. The money a hyperactive investor spends on buying and selling investments is a cost that comes directly out of capital. Those expenses may be bagatelles, but the money is still gone for good. To be a valid use of capital, each and every transaction has to result in a permanent financial gain which earns back the capital which has been lost.

		Many investors like to take profits after a share has risen in value, in the hope or expectation that the share price will decline and they will be able to buy them back at a lower price. This practice is known as market timing and can be hugely costly. To be successful it requires two correct decisions: the first, to sell at the right time, the second, to buy back at the right time. Get either wrong and the loss will be permanent. Trading too actively increases the risk of such an outcome. It is one of the reasons many professionally managed funds fail to perform as well as they should. It also helps explain why fund managers are coming under increasing pressure to lower their management fees, given that transaction costs are now being made more transparent, highlighting what a significant drag on fund performance they can be.

		Resisting the temptation to churn an investment portfolio will make an important contribution towards preserving and enhancing capital. A portfolio of genuine quality growth businesses will flourish if left to mature. Sound investments typically reward the patient investor. The investor is better advised to spend the time saved on manouevring in and out of the market on building up and refining his knowledge of the universe from which his holdings have been selected. Get the business right, in other words, and the returns will follow. The share price today or tomorrow is a secondary factor.

Risk and the eye of the beholder

		Another tenet of established wisdom is that in order to obtain higher returns, the investor is required to take on higher risk. Unfortunately, the established wisdom is wrong. Putting all one’s chips on ‘rouge’ in roulette risks losing all one’s money for a chance to double one’s money – it would be hard to think of a higher risk proposition – but nobody would suggest that this is a sensible way for an investor to proceed. The idea that greater risk is necessary to achieve greater rewards is mistaken. So too is the idea that low-risk assets, as conventionally described, are in fact low risk.

		The safest investment of all, it is said, is cash in the bank, and the next safest is lending to a government by investing in a country’s sovereign bonds. These are both dangerous misconceptions. Take depositing money in the bank first. What that involves, technically speaking, is making an unsecured loan to the bank in return for the payment of interest. (If you are lucky, that is. In the current era, with interest rates so low, the bank depositor can expect little or nothing by way of interest on their deposit.)

		But why should a bank be trusted to repay the loan? Unsecured means what it says: that there is no security or collateral to back up the bank’s promise to repay. If it comes to the crunch, the bank may repay the loan from money it has been paid back by borrowers, but how sound are those borrowers? Nobody can know for sure. During the dark days of 2013, bank customers in Cyprus found out the hard way that banks and governments together can be unscrupulous about ensuring that their political interests override any obligation on the bank’s part to repay its depositors.⁵

		Leaving aside such shocking examples of legalised theft, the reality is that no bank depositor can ever know whether his money is being deployed wisely or irresponsibly. It is true that most governments effectively guarantee bank deposits up to a certain limit (£85,000 per financial institution in the case of the UK; €100,000 in the EU), but the paradoxical effect of the state guarantee may be that it encourages bankers, knowing that they will not be held to account for that money, to take more risk with their depositors’ money than if there was no guarantee. This is one reason the credit crisis of 2007–09 was so severe.

		Nor are government bonds as low a risk as financial theory suggests. Today a vast swathe of the debt issued by European countries offers a negative real return, meaning that bond investors are effectively paying the government for the privilege of lending money to them. An investor who lends money to a government in this way receives next to no interest and, while guaranteed that his capital will be returned at a pre-determined date, has no idea whether that capital will still be worth what it was when it was first lent. Inflation is the greatest enemy of any fixed income investment, and any signs of a revival of inflation will guarantee a real and permanent loss of purchasing power. A bond with a zero or even negative yield is hardly a risk-free proposition.

		So the question for the investor becomes: would he rather lend money to a bank, lend it to a government of dubious integrity, or entrust that same money to participation in the success of the best and most reputable businesses in the world, ones that enjoy outstanding growth over many years to come, wrapped in fortress-like balance sheets with little or no need for debt? Think about it that way, and there is only one logical answer.

		It is true that there are other factors which bear on returns that will always be outside the investor’s control. It is a matter of luck, for example, whether the start of a person’s investing life coincides with good times or bad. Nothing saved a Russian stock market investor from losing everything in 1917 when the Bolsheviks took over, to take the most extreme example.

		Investors in the UK and the United States who made their first stock market investments in the early 1980s had the good fortune to be entering the market at the start of what proved to be one of the most rewarding decades in the history of equity investing. It was hard to go wrong: notwithstanding a sharp price correction in October 1987, and one nasty recession a few years later, nearly everything went up in price more or less consistently. Japanese investors enjoyed exceptional returns, too, in that decade – but those who started in the 1990s had to endure nearly 20 years of poor returns.

		That experience was the mirror image of what happened in the 1970s, when most investors suffered heavy losses in the wake of two oil price crises, a surge in inflation and a global recession. Investors in Japan fared much better in comparative terms in this dark period, with the stock market still learning to appreciate the scale of the so-called postwar Japanese miracle, which saw the country become a new economic force, making household names of pioneering firms such as Sony and Toshiba.

		For the current generation of investors, one hugely positive development has been the revolution in telecommunications and computing that has taken place over the past 30 years. That has spawned the emergence of what are genuinely global markets for shares, bonds and currencies. It has become a simple and relatively inexpensive matter these days for any investor to invest in companies and economies from all round the world, something that was impossible only a generation or two ago. Free movement of capital, independent central banks and the globalisation of manufacturing and trade have massively expanded the number of investment options out there and the ease with which they can be accessed.

		Some experts say that certain types of investments, including many kinds of equity, are ‘not for widows and orphans’. This also is misleading. Sound investments are sound investments, whoever owns them. The behaviour of the share price will not be affected by an investor’s age or status. As popular parlance has it, ‘the share doesn’t know you own it’. If quality growth companies are among the safest and most rewarding of investments, and rightly seen as an independent asset class, it seems strange to try and prevent anyone from sharing in their success, whatever their status in life.

		In the past few years, there have been many examples of sharp and indiscriminate stock market falls that awaken fears of a bear market and are accompanied by sharp rises in volatility. Rather than making investment riskier, the volatility in due course will produce golden opportunities for the level-headed quality growth investor to buy more good businesses at a better price than before. Far from being a risk, therefore, for the investor whose actions are driven by reason rather than emotion, volatility can often be a positive.

		The bottom line is that quality growth companies, in aggregate, offer a potent combination of above-average returns and below-average risk. They will perform well during periods of expansion and display resilience during recessions and other economic shocks. The patient and dispassionate investor who owns them will incur fewer transaction costs. He can concentrate on making sure he knows the businesses to which he has entrusted his savings inside out, for there is no guarantee – only a high probability – that a high-quality growth business will continue to produce the financial results which brought it to attention in the first place.

		The quality growth investor must, of course, be vigilant for any signs that a business is losing its competitive advantage. It requires courage to change one’s mind and to sell, even at a loss, if circumstances have changed and an investment has lost the potential of a serious return. Sometimes it becomes necessary. Continuing to research and monitor performance is therefore a high priority. During bear markets, the quality growth investor has the reassurance that the value of his portfolio will be recovered when conditions improve. Quality growth companies perform well in almost any set of economic circumstances – over time, the investor can be confident that the companies’ 12–15% net earnings growth will translate into investment returns of a similar quantum.

The mind of the investor

		What, one might conclude, is not to like? The answer is that everything comes back to the knowledge and temperament of the investor. It is often thought that investment should be adventurous and exciting – or is, at the very least, the opposite of calm and meticulous. Anyone who describes the stock market as a casino (for good or ill) starts from the wrong perspective. Good investment practice requires modesty, endurance and a lengthy time horizon. It shuns emotion, steers clear of the fashionable and trendy, and ignores the siren voices urging action every day.

		Some investors shun all risk, even if the risk is illusory. They refuse to tolerate even paper losses. They are nervous that equity investments can fall in value at any moment. But if the underlying business is sound, they should be reasoning that the share price will bounce back in due course. The investor should think of shares as he thinks of his house. Assuming his property is in the right location, he can be confident that over time the value will go up, and it does not help to ring an estate agent every day to check the value. Although investments need observation and supervision, just as now and again the homeowner needs to check his roof, it is a mistake to tamper with them all the time.

		The investor who follows what this book suggests will construct a quality portfolio of equities designed to survive bear markets as little battered as possible; and then to take wing when optimism returns and the growth in earnings of businesses with sound balance sheets again becomes reflected in the price of their shares. In this game the determined tortoise will always beat the excitable hare.

		Above all, it requires the investor to take care that his money survives and grows amidst every vicissitude that politicians, the economy or the markets can inflict. Although the vicissitudes of these outside factors often have unique characteristics, many of them apparently compelling, common sense should dictate that the investments themselves are what really matter.

		A focus on the businesses that meet such demanding criteria will eventually reward his patience, and in abundance.

* * *

		 			1 I often feel that the English language, which is so richly variable, should by now have found a way of describing a person with a polite pronoun that covers both the traditionally used pronouns ‘he’ and ‘she’. Sadly, that magical pronoun has failed to emerge, meaning that business books and legal documents tend towards using the male description only when the author would be far happier with a word that encompasses both. Please bear with me for resorting to the use of the traditional masculine pronoun when referring to ‘the investor’ in this book – I assure you that I mean this to address both sexes equally.

		 			2 The criteria used by GMO include a high return on capital, consistent profitability and strong balance sheets with relatively low amounts of debt.

		 			3 This is based on the assumption that the stock market produces an average return of 6% per annum, which is consistent with the long-run historical average.

		 			4 It is true that, in the very short term, in the early days of a severe market downturn, the shares of larger high-quality businesses may be marked down more dramatically than risker companies because they are the only shares which can be sold quickly by cash-strapped or panicking investment institutions (an example of the liquidity factor described in the next chapter). Over the course of a bear market, however, the findings of the GMO study will turn out to be correct.

		 			5 As the price of bailing out its banking system, Eurozone politicians unilaterally forced customers of Cyprus banks to give up a significant proportion of the money they had deposited at the bank.

Chapter 2:

		The Bigger Picture

		While good managements do everything in their power to sustain and grow the profitability of their businesses through good times and bad, even the highest quality growth companies are not immune to wider developments in the economy, politics and society. The quality growth investor needs to be aware of what these developments are, and monitor them closely – but it is also important to keep their relevance to his investment strategy in context.

		This chapter discusses in more detail how these bigger picture issues can and should impinge on the investor’s decision-making. While his main focus will always be on the businesses he owns – as they are the engine which is the source of his investment returns – there can be times when other factors will inevitably intrude. The challenge is to maintain a measured response to events, which will often attract a high profile in the media and day-to-day discussion but may not always be as relevant or as important as they first appear.

What drives markets?

		The investor must always be alert to the three ingredients that make up a market and explain its behaviour, whether it is rising or falling. These three factors are growth, liquidity and valuation. Over time all three are subject to change, tempting the investor to make adjustments to his portfolio. It is often wise to resist such temptations.

(i) Growth

		Growth is one of the keys to stock market performance. Bull markets reflect the economic growth of a country. Rising share prices mirror a rise in the profits of the individual businesses that make up a country’s economy. The distinctive feature of stock markets, however, is that share prices will typically rise in anticipation of stronger earnings and are themselves one of the main leading indicators of future economic development. This leading indicator role also works in the other direction. Early and material share price declines often presage an economic deterioration that follows a few months hence.

		In more cases than not, its role as a leading indicator is the reason why, as the saying goes, the stock market is ‘always right’. It is an observable fact that when a country’s statisticians declare that an economic recession has taken place, it always turns out that the start of the recession will have been preceded by a fall in the stock market several months earlier. It is the stock market’s job to look forward and anticipate the future course of economic growth. With hindsight it fulfils that role well. The only problem is that, while all recessions are preceded by a stock market decline, not every stock market decline is the precursor of a future recession.

		In other words, the stock market can also give false signals, and typically this will occur when investors succumb to their emotions, or some startling new narrative arrives to encourage irrational fears or hopes. These episodes are one of the forces that contribute to the volatility of the stock market. It is during these periods that share prices can move away from their fundamental value, creating opportunities for the well-informed investor to buy or sell to advantage. It is part of the analyst’s job to try and distinguish those market declines which foretell a decline in future economic growth and those which are merely giving out a false signal.

		As explained in the previous chapter, although the quality growth investor’s portfolio will consist of businesses that can continue to grow through a recession, a declining stock market will not leave a quality growth portfolio unscathed. For the seasoned investor, with nerves of steel and cash to spare, however, bear markets always eventually present a new buying opportunity. The economy will start to recover and, some months before that happens, stock markets will start to rise. If the investor can identify that point, there will be substantial gains to be made by buying more shares in his favoured quality growth businesses.

		Buying high-quality growth stocks when prices are depressed by general economic conditions is a surefire way to deliver superior portfolio returns for many years to come. Identifying that possibility is, however, easier said than done. The reason is that it is precisely at such low points that investors, still reeling from heavy losses, will be at their most fearful and the media will be full of gloomy news and backward-looking tales of woe.

		Nothing alters the fact that company earnings in aggregate will struggle to grow if the economy of the country as a whole is not growing. The quality growth investor’s universe, however, is – as a matter of choice – limited to companies which have shown themselves capable of enjoying superior growth under almost every kind of economic scenario. Their financial performance will be better than most during bear markets – and be strong during subsequent recovery periods. The rate of economic growth will always be a factor that drives and constrains how much growth a company can achieve in absolute terms.

		It is important to distinguish between nominal and real economic growth. The first is the headline figure by which the economy expands from one period to the next. The second, and far more important, is the rate of growth after allowing for the rate of inflation in the economy. Nominal growth only tells half the story. The other half is about the direction of prices. Rampant inflation is dangerous; persistent deflation, when prices generally are falling, is even more dangerous. A generalised fall in prices across an economy risks turning a short-term economic boom into a recession, followed in the worst case by a deflationary bust of the kind that brought about the Great Depression of the 1930s. This is a nightmare scenario and one that will guarantee to devastate the stock market should it occur.

		Today, when consumers are making increasing use of the internet to shop around and drive down prices, booms and busts are generally less pronounced than they were. Inflation has stayed at very low levels, at least by 20th-century standards, for many years now. That is another reason why quality growth businesses have performed so well; they are among the few examples of businesses still capable of putting up prices in a low-price world. The biggest danger the investor faces on the growth front is the potential impact of rare exogenous events, outside his control, that could bring economic growth crashing to a halt. The oil price crises of the 1970s are an example. Trade wars or military conflict between superpowers would be more current examples.

(ii) Liquidity

		The economic cycle and stock market behaviour are also dependent on a second variable, which is the amount of liquidity in the global or national economy. Liquidity refers broadly to the amount of money or spending power available to consumers, producers and governments. It comes in a variety of forms. In a macroeconomic sense, it refers to the amount of money in circulation or available as borrowing from banks, while central banks are also heavily involved through the operation of monetary policy in determining the amount of liquidity available at any one time. In the microeconomic sense, liquidity refers to the amount of uninvested money in institutional and private household accounts. In private households it is savings, the difference between earnings and expenditure.

		Liquidity is important to investors because it is the oil that lubricates the economy, as well as being a major influence on the amount of money flowing into stock and bond markets. Nowadays, central banks hold all the cards when it comes to liquidity. They have the ability to restrict or increase the amount of money at will. They use that ability in an effort to control inflation and the rate of economic growth. In the years since the global financial crisis, central banks have been using their powers to create unlimited money out of nothing to the full (a policy known as quantitative easing). This new money is then placed at the disposal of the banking system in the hope of making them more willing to lend. At the same time the central bank tries to make it unattractive for banks to hold excess reserves, sometimes by imposing negative interest rates on their deposits with the central bank.

		At the time of writing the amount of liquidity moving around the economic system is still abundant and that is considered by many to be a factor in the strong showing of stock markets over the last ten years. The tide of liquidity unleashed by the central banks is designed to counter disinflationary expectations holding back both consumption by households and capital expenditure by business, two of the most important drivers of economic growth. A shoe manufacturer will slow down his production of shoes if he expects to sell them at a loss. Equally, the customer will refrain from buying the shoes if he believes they will be cheaper in a few months.

		Globally, economic growth has been slow for several years, which along with low inflation rates has in turn had a depressing effect on another factor which is an important influence on stock and bond markets, namely interest rates. Slow growth has kept interest rates low, to lure money away from the sidelines and towards consumption and investment. Interest rates are important for the liquidity of investment portfolios. The higher they rise, the more attractive fixed-term deposits and savings accounts become as an alternative to shares and bonds. Higher interest rates also make companies think twice about borrowing. With the confluence of these two important trends, liquidity is gradually reduced and reluctance to buy shares mutates into unreadiness and inability to invest.

		Investors need to track the policy of central banks and, in particular, trends in interest rates and liquidity, as they are such important determinants of the amount of money flowing into the financial markets and the economic conditions in which businesses of all kinds have to operate. In particular, the extent to which the Federal Reserve in the United States and other important central banks are relaxing or tightening monetary policy is a critical variable in future rates of inflation and economic growth, which in turn are key drivers of the future path of corporate profitability.

(iii) Valuation

		The subject of how the investor should value individual quality growth businesses in which he is considering investing is covered in chapter 6. Here we will address how the stock market as a whole is valued. As already noted, the role of a stock market is to discount the future earnings of each listed company, using a rate of interest, to give these earnings a present value. This value is often expressed as a price-to-earnings (p/e) ratio, meaning, in the case of individual companies, their market value as a multiple of their current profits. A p/e ratio can also be calculated for the market in aggregate. Fluctuations in the price of money will affect the p/e ratios of individual stocks and of the market as a whole.

		The topic of valuation ranks as one of the most widely debated issues in investment. Most investors put it at the top of their priority list. After all, they reason, the cheaper an investment opportunity, the more they can gain and the less they can lose. The higher it is priced, the greater the potential for losing money, either on paper or permanently. Such investors are drawn to a style of investing known as value investing. At its most extreme this is characterised by a share which, as Benjamin Graham had it, has a wide and strong safety net. That safety net, in his view, would ideally be represented by the existence of a large disparity between the price of a share and the intrinsic value of the net assets on the company’s balance sheet.

		So if the investor calculates an investment to be worth 100, and its share price is trading on the market at 60, it represents a potential bargain, and one where there is a lesser risk of loss than if the share price traded at 70 or 80, let alone 120 or 150. This, of course, is on the assumption that the business is correctly valued at 100, which is not always the case. The pricing of the business in the case of a Graham follower would relate to the value of the company’s net assets, although because assets come in various shapes or forms, including intangible assets, valuing them correctly is a task in itself.⁶

		Value investing in this narrow sense worked well in days gone by, but is less practical these days. There are many other approaches to valuing both an individual investment and the market as a whole. It is the most complex of the three panels of the market triptych, because it also hinges on and interacts with the two other panels, growth and liquidity. In essence, a higher rate of economic growth translating into above-average profits expansion, say, would generally merit higher valuations than those prevailing in a sluggish economic and profits environment. A dearth of liquidity, on the other hand, could place a question mark over the reliability of any particular valuation.

		Interest rates are also an important factor in determining the rate at which future earnings should be discounted to arrive at the present value of both the overall market and individual companies (see below). Currently interest rates are very low and, other things being equal, this would be expected to contribute to higher rather than lower share prices. Many investors, however, believe that this environment is abnormal, even artificial. They argue that the interest rate used to discount future earnings is too low, meaning that p/e ratios are too high and the stock market is therefore due for a correction.

		There is plenty of scope for arguing about the current level of valuations. My personal view is that the critics who think valuations are excessive are misguided, having failed to appreciate the strength of the deep-seated forces which have contributed to the low-growth, low-inflation, low-interest-rate world which is the current norm. Failing to read the runes, aficionados of value investing have been far too cautious for years, missing out on one of the longest bull markets in recent history. This is discussed further in chapter 7.

		The overall lesson for the quality growth investor is that understanding the factors which influence the valuation of the stock market is an important part of his responsibility. Growth, liquidity and valuations combine to shape the direction of the stock market, but they can combine in different and complex ways. There can be an absence of growth and liquidity, while valuations are still appealing. There can be an abundance of growth and liquidity, but valuations can be daunting, as they were in 2000 at the height of the dotcom bubble. Any combination is feasible. At the time of writing, valuations are reasonable, underpinned by steady if unspectacular economic growth coupled with abundant liquidity. But there is always the possibility that these can change quickly and unexpectedly.

The bond market and interest rates

		There is an unchanging and unbreakable connection between shares and bonds. As taught in academia and business schools, the risk-free interest rate offered by long-duration sovereign bonds is the basic benchmark, or hurdle rate, against which the investor needs to measure the value of any potential investment. When valuing a potential equity investment, the central issue is the additional return over and above the risk-free rate that is required to justify making the investment. This required rate is known as the equity risk premium.

		The reason that equities require a premium, so theory has it, is that shares are assumed to be riskier than sovereign bonds and their return should therefore exceed that of the alternative ‘risk-free’ investment. The equity risk premium, it is taught, can vary from one country to another, depending on the stability of the region in question. Argentina or Venezuela, for example, will command a higher risk premium than Germany, France or Switzerland.

		Whether the theory taught in business schools accurately reflects the way the world works can be challenged, but what is not in doubt is that the price of money, as reflected in market interest rates, has a central and profound influence on the operation of financial markets. Many investors who find shares more interesting than bonds overlook the fact that the share market tail is always wagged by the bond market dog. Numerically the bond market is the big brother of the equity market, since the aggregate market value of fixed income paper listed on the world’s stock exchanges is greater than the equivalent in shares – and the disparity in size between the two markets is growing ever wider.

		In the first ten years of the new millennium, the size of the bond market grew more quickly than the US economy. By 2010 the value in dollars of all issued fixed income paper was nearly double the market capitalisation of all listed shares. The bond market is the most important influence in determining the behaviour of every economic agent, up to and including central banks. It is also the determining factor in the price of money. To the extent that it encourages more efficient pricing of risk, the trend towards deeper bond markets should be welcomed by equity investors too.

		The importance of the bond market has grown since governments began to impose new capital rules on the banking system after the crises around 2008. The new regulations mean that banks are forced to be more careful about their lending. With banks lending less, companies seeking finance have increasingly had to turn to the corporate bond market, helping to fuel its rapid growth.

		That makes it even more important for the investor in shares to be aware of trends in yields right across the bond market, and not solely in the government debt market. It is hard for modern-day investors to recall that, until the 1980s, there were no corporate bonds in issue in the UK market. Similarly, in the United States, high-yield bonds – sometimes known as ‘junk bonds’ – have grown from nothing to become a multi-trillion dollar market.

		Why is this question of the price of money so important to the equity investor? The reason is that interest rates are the most important influence on the direction of share prices. The job of stock markets is to place a value today on the earnings that companies will make tomorrow. Interest rates provide the discounting mechanism that determines the present value of a company’s future earnings. A risk-free rate, or as close to it as possible, is needed as the building block on which the discounting exercise is based.

		Other things being equal, any rise in the discount rate will tend to reduce the present value of future company earnings and so produce a weaker share price. In the same way, a lower discount rate will tend to have the opposite effect, leading to a general increase in share prices. The precise linkage between market interest rates and equity valuations however is never straightforward in practice.

		Historically, for example, the risk-free rate has generally been taken to be the ten-year government bond yield, to which is then added any relevant equity risk premium. But is that still appropriate in a period when interest rates have been held so low as a matter of policy and government debt has risen as dramatically as it has done since the global financial crisis? What is the most appropriate equity risk premium to add in the case of the long-life companies which the quality growth investor favours? These important issues are discussed further in subsequent chapters.

Bull and bear markets

		Bull and bear markets have always been a feature of financial history and are an essential topic for study by any investor. Much is made of the importance of being a contrarian and how the expectations of the majority at any point in time may turn out to be wrong. But being a contrarian should not be an aim in itself. It only pays off for courageous investors at market inflection points. Since it is rarely possible to recognise a market inflection point until after it has occurred, the ability to recall past inflection points is important.

		At turning points in the market cycle, there are often telltale signs of greed or fear. In the former case, caution is thrown to the wind and the prospect of returns trumps all concepts of risk. If the investor sees markets rising day after day, and week after week, and all around him are making money and boasting about it, it is likely evidence that a market top is near. Joining the madding crowd at such a point is a precursor to losing money, usually permanently.

		In the case of fear – the emotion most associated with troughs in the market cycle – the opposite holds true, as investors close their eyes and ears to investment opportunities. Some investors take a vow never to return to the market, having incurred a permanent capital loss. As they drop out at the bottom of the cycle, they initially feel elation at dodging the hammer blow of losing money, only to repent at leisure over missed opportunities.

		In the spring of 2009, for example, there was little or no market optimism. Many participants had been beaten down. Stock markets barely differentiated between quality and junk. Quality growth businesses were on offer in the market at absurdly low prices. It turned out to be one of the greatest buying opportunities of all time. Those who were brave enough to take advantage have enjoyed compelling returns ever since. That was a good moment to be a contrarian.

		Another example came in the early weeks of 2018, when the vast majority of investors were convinced that long bond yields were about to break out of their recent historical trading range, rise strongly in anticipation of the return of inflation and challenge the dividend and earnings yield of shares. As it happened, the majority of investors were wrong. Bond yields did not surge, nor did inflation return. If equity prices were challenged, it was the result of different forces.

		To prevent emotion from taking over from reason, the investor periodically needs to take three steps back and look at the big picture. As mentioned earlier, his primary considerations will be the triptych of growth, liquidity and valuation. If it were easy to spot the turning points in the market cycle, investing would be much easier. But a careful examination of those three variables, combined with the benefits of experience, can sometimes create unbeatable opportunities to profit from the misjudgements of the majority.

Political and economic influences

		Unless there is a high perceived probability of a radical change in prevailing economic policy, political currents frequently dominate media headlines, but rarely have much lasting influence on markets in developed countries. They assume more importance in the run up to elections, when the potential for a change in government becomes more real. Investors historically tend to worry if they perceive that a government with left-wing policies is about to be elected, but are more relaxed if a right-of-centre government is predicted. These concerns usually turn out to be transitory and initial expectations are soon eclipsed by events that have more direct consequences for investors.

		Left-leaning governments which set out to increase the role of the state in business are likely to see their country’s stock market underperform compared to periods when right-wing governments are in power and the threat of government interference is much less. It may not always be that simple, however, as Donald Trump’s victory in the 2016 US presidential election has shown. The election of a Republican candidate with many years of experience as a property developer (albeit not always a successful one) raised the prospect of reduced government interference in business.

		It was swiftly followed by a surge in the prices of shares of cyclical businesses, leaving quality growth companies trailing. His promise to dismantle much of his predecessor’s policies had an immediate and positive effect on healthcare and bank shares. Interest rates and long-term bond yields rose for a while in anticipation of what was termed Trumpflation, the likelihood that his policies would soon feed through into higher rates of inflation. The dollar also rallied strongly, in part because of a likely repatriation of foreign assets.

		But second thoughts soon set in, confirming the wisdom of the observation by former Governor of New York, Mario Cuomo, that politicians “campaign in poetry and govern in prose”. Within months of his victory, the popular Trumpflation trades were abandoned and the stock market reversed course. Meanwhile President Trump’s efforts to strengthen his blue-collar following in the rust-belt states by launching a protectionist war of words with China and other countries also began to rattle investors. The announcement of import tariffs on steel and aluminium raised the prospect of a trade war in which there would be no winners. Trump’s verbal attacks on large US technology companies such as Amazon and Facebook also did not go unnoticed by investors. Yet none of these concerns prevented the US stock market achieving a new all-time high in 2019.

		Experience suggests that it is easier to identify potentially damaging political developments than to assess their likely impact. One example which has attracted a lot of attention is the strong suspicion of Russian interference in the democratic process of other countries. Cross-border influencing of people’s attitudes and behaviour through social media channels has been evident for a while now, an early example being the Arab Spring protest movements some years ago. More recently, Russia stands accused of meddling in the US presidential elections that brought Donald Trump to power. Some people also suspect that Russia might have played a role in the outcome of the Brexit referendum as part of its quest to divide and weaken the European Union.

		The Brexit referendum itself has had a profound impact already on financial markets, even though at the time of writing, three years on from the vote to leave the European Union, the UK has yet to do so. The external value of sterling has fallen to levels last seen 30 years ago. That has boosted the share prices of many exporting businesses, which are now enjoying a more competitive exchange rate, while those of many domestic-oriented companies have in contrast fallen and remain badly out of favour with investors.

		But it is still far too early to know when and how (or indeed whether) the UK will leave the EU. The outcome for the economy and financial markets will depend to a great extent on the ability of the UK to negotiate new trade deals and settle its future role in global trade and finance. If sterling’s leading role in financing international transactions is lost, or used progressively less, it would have profound effects on a portfolio of British investments. If the City of London’s role as a world financial centre is diluted, and business moves elsewhere, the damage will be considerable. In this case a political development will prove to have been of great significance to the investor.

		If, on the other hand, the UK continues to play a leading role in global economics and finance, politics will return to its normal secondary role for investors. There may be consequences of a different kind if there is a general election and the result is a far-left anti-capitalist government led by the Labour Party’s current leader, Jeremy Corbyn. This party has threatened to introduce a series of very different policies, including the confiscation of private sector assets at knock-down prices and a massive expansion of public spending financed by money printing. If this were to come to pass, it could have a dramatic effect on the stock market, with negative implications even for the quality growth investor.

		The same uncertainty applies to the future of the European Union. In many countries populist politicians from both the left and right are proposing radical policy solutions that threaten the centrist approach which has characterised much of the EU’s history. They often involve attempts to protect national economies from otherwise inevitable and growing globalisation and foreign influence. This could significantly affect the bottom line of local businesses, whether international or domestic.

		The most striking example of the rise of anti-establishment parties occurred in the Italian parliamentary elections of March 2018, when the League and the Five Star Movement, two parties with quite different policies, obtained a sufficient majority to form a new government together. This government’s plans to ramp up spending and lower tax rates simultaneously was quickly noted by financial markets, causing a sharp market downturn. The knock-on effect was felt right across the euro area, with bond yields widening sharply against their benchmark, the German government bond.

		Europe is also experiencing a rise in support for regional independence or autonomy, notably in Spain, Italy and Scotland, to name the most obvious. The anxiety created by waves of immigrants coming to Europe has helped to spawn nationalist movements. Here, again, however, it is too early to predict whether the economic liberalisation that Europe has enjoyed for the past three decades will be replaced by harmful protectionism, leading to higher inflation and interest rates. Were this to happen, no investor would remain unscathed.

		Political influence on financial markets is a rather different matter in developing countries, where governments often seek to retain more direct control of their economy. In 2015, for example, the Chinese government began to engineer a shift in its economic policy away from a focus on infrastructure and other capital projects towards greater encouragement of consumer expenditure. As a result, China’s previously huge demand for commodities and raw materials subsided, causing a global slowdown in economic growth and precipitating a violent reaction in financial markets across the world at the start of 2016. In the event, the fears of economic disruption moderated as economic data showed that investors’ sudden pessimism had gone too far.

		Investors’ experience in Latin America has tended to be even worse. Economic xenophobia and class resentment often resonate with disgruntled voters in over-indebted and closed economies. In recent years Argentina has nationalised its private pension funds and Venezuela has seized ownership of foreign-owned local energy companies, scaring away badly needed foreign investors. Capital markets, especially fixed income markets, remain underdeveloped in Latin America. Hostile government policies mean that anyone investing directly in companies listed on local stock exchanges runs a serious risk of permanent loss of capital. (Fortunately, but unsurprisingly, few businesses that meet the requirements of the quality growth investor are to be found in these countries.) While new dawns have been called with great regularity over the past 50 years, they usually turn out to be false.

		Another recurrent potential area of concern is geopolitics. In 2017, the unreliable behavour of the North Korean dictator Kim Jong Un attracted considerable attention, given his country’s ambitions to test and develop a nuclear weapons capability. The uncertainty over North Korea’s intentions prompted periods of stock market volatility. A meeting and subsequent brief ‘bromance’ between Kim Jong Un and Donald Trump appears to have reduced the immediate risk of escalation. Nonetheless, the eventuality of a full-scale nuclear war cannot be totally discounted, and clearly any such risk would not go unremarked by financial markets.

		It is never possible to discount the role that political developments can play in shaping the behaviour of financial markets. Investors are quick to react to any perceived change in the status quo and it takes time for what is often a rather different reality to play out. The good news for the quality growth investor is that the impact is typically transitory and mostly irrelevant to the performance of the businesses in which he has invested.

		Solid businesses which meet the stringent quality growth requirements will continue to produce solid earnings as long as we continue to operate in an unfettered, free world economy. Their earning power will not suffer unduly from minor changes in economic management by politicians. To achieve a strong track record of growth, they will already have needed to prove themselves able to adapt to events and circumstances. While their market valuation may go through periods of stress, it should not normally affect their long-term potential.


		The macro considerations of growth, liquidity and valuation will act as a guideline to overall market conditions; but the forces that drive the long-term returns to a portfolio of quality growth businesses are mostly independent of today’s headlines. Trends such as the growth in online payments and internet shopping are clearly developments that are relevant to the business models of specific companies and in that sense worthy of more attention than noisy political posturing. Bond yields and the trend in monetary policy are, however, fundamental to analysing the market and economic cycle, as well as key to the valuation placed on different companies. The quality growth investor neglects the bond market at his peril.

		When high-quality growth businesses do come under a cloud from some perceived external threat, it can be an opportunity for the vigilant investor to add to his holding. Momentum is a powerful short-term factor in shaping stock market prices and the effect can be to drive the price of a good company some way away from its intrinsic value. As long as the investor is confident that the fundamental earning capacity of the company is unaffected, adding to a holding in those circumstances is not an act of faith, but good business. There will always be opportunities to add value if the emotional response of others leads to temporary mispricing of the narrow range of quality growth stocks in his investable universe.

* * *

		 			6 In his classic formulation of deep value investing, Benjamin Graham advocated looking for companies whose market value was less than their stated net tangible assets.

		Part II: How

Chapter 3:

		The Ten Golden Rules

		In this chapter I set out the ten golden rules that help us define the small number of shares that meet the criteria a quality growth investor is seeking. I have arrived at these rules through both analysis and experience gained over more than three decades.

		It is important to note that when we talk about quality growth investing, we are using the words quality and growth in a specific and mostly measurable sense. Quality is defined by the balance sheet of the business, by how good its assets are and by the calibre of its management. The four pillars of quality are:

		the company’s track record

		the strength of its balance sheet

		the accounting practices it adopts

		its governance (how it is managed).

		Growth, on the other hand, is measured by the company’s ability to generate increases in:


		profit margins

		cash flow.

		The increase in a company’s share price over time is closely and logically correlated with the growth in its earnings. That is not true for all companies, however. If a company has an abundance of debt, its share price will be influenced by the cost of this debt and by the prevailing rate of interest when the debt is refinanced. Its share price will also reflect the market’s view about the risk of bankruptcy for the company.

		Similarly, if a company is listed in an emerging market, the share price is also likely to be influenced by a country risk premium. Investors will demand higher returns if the country is perceived to have higher political and governance risks. These influences are, crucially, outside the company’s control and set independently by financial markets.

		The quality growth investor prefers not to allow these external variables to get in the way of the growth fundamentals that matter most, namely earnings, margins and cash flow. By sticking to the investment principle of a strong balance sheet largely free from debt, and avoiding the higher risk of an emerging market listing, the business’s long-term growth trajectory will be reflected more reliably in the returns obtained by shareholders.

		It is true that, once the quality and growth ingredients of a company have been established and an investment made, patience will be needed. As long as the expected growth materialises, the investor can have confidence that it will be rewarded in superior share price performance. It may, however, take some time, which is why patience is such an important requirement.

		So while quality growth stocks can never be wholly immune to the market’s moody and volatile movements from day to day, their long-term performance is assured as long as their long-term earnings growth remains durable and above average, backed by a rock-solid balance sheet. That is an empirically observable truth for those who care to study the historical data.

		(As an aside, there will be times when the share price of a quality growth stock will anticipate the future growth in earnings. This can be disconcerting for the investor. This observable correlation negates the efficient market hypothesis, the business school theory that all publicly available information is in the price of a share at any given time – ignoring both market irrationality and the fact that profound research can unearth aspects of a business not widely known. If a bad day on the stock market causes share prices generally to drop, why should this reflect a deterioration in the business prospects of all the companies whose share price fell? It is simply the result of a bad day and can be reversed over the next session.)

Defining the universe

		This is how the quality growth investor begins the challenge of creating a portfolio. The first step is to define a universe of possible candidates from which the final portfolio will be selected. The primary objective is to find an industry whose growth rate is, or is set to be, above that of the gross domestic product of the country or countries where the company is conducting its business.

		In this search, the investor will take note of paradigm shifts in economic behaviour, such as the trend towards cashless payments, or the growth in online shopping, to name but two obvious examples.

		The detailed task is to find the best companies in that industry, based on these ten characteristics:

		A scaleable business model.

		Superior industry growth.

		Consistent industry leadership.

		A sustainable competitive advantage.

		Strong organic growth.

		Wide geographic or customer diversification.

		Low capital intensity and high return on capital.

		A solid financial position.

		Transparent accounts.

		Exceptional management and corporate governance.

		It does not take long to discover that companies which can meet all these demanding criteria are few and far between. Approximately 50,000 shares are publicly quoted in OECD countries. No more than five or six dozen companies from this list will meet the requirements we have set. At Seilern Investment Management, we repeat this screening exercise on a regular basis and the current size of what we call our investable universe is just 60 names.

		The names that do emerge from this process rarely come as a great surprise, since to meet the criteria they will usually already be well-known and established businesses. Quality growth investing does not encompass start-up businesses and one of the most important qualifications for inclusion in the universe is a consistent track record of profitability and growth. A dominant market position is likely to be one reason for their sustainable competitive advantage.

		Industrial companies can be fascinating in this regard. Take water pumps, for example. A pump built 100 years ago has little in common with one built today. Yet the best pumps on the market today are still manufactured by the same company, Xylem. How is this possible? What counts in the long term is not just a company’s ability to navigate the ups and downs of the economic cycle (most will survive if they have the right balance sheet), but also the ability to lead and share in never-ending cycles of product innovation.

		Innovation affects quality growth businesses in different ways. Some have low innovation content. Whether they admit it or not, consumer staple companies such as Unilever or Danone belong to this group. These companies tend to spend little on research and development, but a great deal on marketing. Many of the larger companies have in recent years set about centralising decision-making in the interests of cost efficiency. That has produced savings and higher profits, but at the cost of allowing local competitors in some key markets to steal a march in terms of product innovation and speed of response to changing local tastes. The lack of speed in reaction to changing markets has begun to cost them market share and to disrupt one part of their business model.

		Another group of quality growth businesses value innovation – but pursue it over a long cycle. The way payments are made, for example, does not change every year. But large companies which continue to invest sufficiently in innovation are able to remain well ahead of their competitors and are correspondingly harder to catch up. Examples here include Automatic Data Processing, Mastercard and Dassault Systèmes.

		A third group of quality growth businesses is the one where innovation is rapid and essential for corporate survival. If a business ceases to innovate and adapt to changing market dynamics, it rapidly disappears (who now remembers Eastman Kodak, which once dominated the market for camera film?). Good examples of companies which have thrived in a fast-changing innovation environment are Xylem in water technology, Graco in fluid-handling systems, and Assa Abloy in doors and locks. These quality growth businesses manage to remain industry leaders despite high turnover in their products.

1. A scaleable business model

		A quality growth company must have a scaleable business model. What does that mean? At its most basic, a scaleable business model is one that allows a business to sustainably grow its revenue and profits. The market for its products must be sufficiently large and open to absorb the company’s continued growth. This is key. If the market is too small or too closed to support the company’s growth, it follows that its sales and earnings will not be able to expand at the required rate. It is upon this foundation that the different methods of achieving scalability are built.

		Here are some examples of business models that meet the demand of scalability.

(i) The platform model

		In its purest form, a platform is a mechanism to create interaction between separate groups, most often the producers of some good or service, its inventors and the consumers. The success of this model is based on two key ingredients: continued scope for revenue growth and the ability to control business costs. The mechanics are simple to grasp – the business requires an investment in infrastructure to support growth – but the investment required is minimal by design.

		Within the platform model, there are two dominant sub-models: price and volume.

		The price-scaleable business has a stable cost base, and revenue growth is generated predominantly through pricing power. This is the sort of model operated by Rightmove, the UK property portal. Rightmove offers its end users (the country’s potential house buyers) the widest range of property listings in the UK, and its customers (estate agents) access to those end users. Since access to potential property purchasers is a business-critical service for estate agents, and the cost is a fraction of the cost of running an estate agency, they are almost guaranteed to list their stock of houses on Rightmove. The result is that Rightmove has captured most of the growth in the market. Because of t