Every once is a while the stock market, in its collective wisdom, makes an important statement. I believe one such pronouncement was made on Friday, that “Quality” will carry the day. In this I have no doubt. In Friday’s volatile trading in the financial sector we saw this flight to quality play out in a huge way. The stock market made a bold statement that the three strongest banks are Wells Fargo, JP Morgan and Bank of America, as their respective stocks advanced about 10%. At the same time, struggling institutions like National City and Wachovia took it on the chin with their stocks plummeting about 30%.
Meanwhile, the Oracle of Omaha himself, Warren Buffet, who passed on investing in Lehman and Bear Stearns, poured $5 billion in Goldman Sachs, long regarded as the best managed brokerage and investment banking firm.
Shaken to the core… It is fair to say that our financial system has been shaken to the core. As we all await the government’s rescue plan, investors have got to be searching for some sense of normalcy. But these are far from normal times. Are we confident in the government’s ability to reset the financial system? Are we confident in our financial institutions, our markets, or even in capitalism itself? I suspect even the bravest of souls have some degree of doubt.
So, how do investors weather these unprecedented and very trying times? Supported by the message from the market on Friday, we are confident that our focus on quality is the right strategy for the current environment. More specifically, our approach is threefold, in which we define quality, identify quality and commit to quality.
Define quality… We define quality as the sustainable competitive advantages that a company holds over its peer group. These advantages relate to: product, price, cost structure, technology, market share, financial strength, management vision, and overall execution.
Identify Quality… One particularly critical determinant of quality in today’s environment is financial strength. One way this can be measured is by the debt ratio.
The average debt ratio for our core portfolio is approximately 23%, which is considerably less than the average debt ratio for the S&P 500 currently at 33%. With credit extremely tight, companies with excess debt capacity, or the ability to finance operations internally, have a strategic advantage.
Another important advantage necessary to weather these difficult times is to have market share leadership. Virtually every company represented in our flagship equity portfolio holds the #1 market share position in their core business. In general, having the largest market share position offers economies of scale in production and advertising that can be critical during challenging environments.
A decided cost advantage is also a key attribute of quality. Intel in microprocessors and Nucor in steel are two examples of companies that hold significant cost advantages in their respective industries.
Focused management with the right balance between being opportunistic, but disciplined and patient is another important competitive advantage that leading companies possess. James Dimon at JP Morgan would rank high on this list. I would add that the final jury is out concerning JP Morgan’s latest moves to buy Bear Stearns and Washington Mutual. Ditto for Ken Lewis regarding Bank of America’s acquisition of Merrill Lynch. We’ll definitely have more to say about these unprecedented deals over time.
Commit to quality… During difficult economic and market environments this might be the toughest part. In emotionally-charged environments high quality stocks can fall as investors operate under a “ready, fire, aim” approach. But this is where disciplined, long-term investors rise to the top. Quality is never cheap, and rarely on sale, but it is at these infrequent moments when fear has seized the day that experience and commitment will eventually be well rewarded. Of this I have no doubt.
