Quality Investing

Quality, Quality, Quality

I briefly touched on the subject of quality investing when I wrote about The Importance of Long Term Investing. On that page, I stated that, "Long term investing makes it easier to focus on only high quality companies."

But the concept of quality investing is so crucial that it deserves its own page.

Choosing High Quality Investments

The great value investors, from Benjamin Graham to Warren Buffett, have understood and articulated that stock ownership is ultimately about business ownership. When you purchase shares of a stock, you own part of an actual company, not slips of paper.

Seeing yourself as part owner of a business instead of merely a generic shareholder changes your perspective. You're literally going into business with the company whose shares you own.

I would argue that the same goes for the options you trade. Others might disagree, but keep in mind that an option is a contract that represents 100 shares of the underlying stock in a very real corporation. As an options trader you may never touch a single share of stock, but without stock, there would be no options market.

So why would you choose to invest in or trade any company that wasn't a bastion of durablity and profitability? Why would you ever consider dealing with any company that had less than a stellar balance sheet? If they aren't best of breed businesses, why would you ever do business with them?

The Lure of Inferiority

The reason why quality investing isn't universal investing is actually very simple: crap moves around a whole lot more than quality does. And there's so much more of it.

Be honest now. Of all the stock and options positions you have ever held, what percentage consisted of truly high quality companies? How many were businesses you would be willing to own over an entire lifetime? If you're like the rest of us, most of the securities you've dealt with had more to do with recent stock performance than long term and incredibly sound business fundamentals.

It's not just momentum players or premium chasers who are guilty of settling for partnering with mediocre, and sometimes inferior, businesses. What frequently passes for prudent, long term, investing guidance - namely the need for diversification - is, in actuality, abysmal advice. Putting your money into mutual funds, index funds, or ETFs consisting of dozens or even hundreds of stocks is a really efficient way to ensure lousy performance.

Blind investing is not quality investing. It's an abdication of your own entrepreneurial responsibilities and is suitable only for those with absolutely no aptitude or desire for real investing. Please don't be insulted - if you're reading this, you're already miles ahead of the indifferent crowd.

But giving your money to a mutual fund manager with way too much money to manage nimbly and whose performance is tracked on a quarterly basis guarantees that you're going to be part owner of a ton of average businesses as the fund "diversifies" and continually churns its positions.

So What's So Great About Quality Investing?

There are two fundamental advantages to owning a quality business over owning an average or even an inferior business -

You're much less likely to suffer permanent losses
You're probably going to make a lot more money over time

Don't forget that the point of owning a business is to make money with limited effort (i.e. risk and stress) on your part. Economic downturns, volatility, and market plunges are guaranteed events that, in the long run, have little ability to derail the long term success of the quality investor.

In contrast, it's the mediocre and "properly diversified" investor that gets battered the hardest when the inevitable storms come. Why? Average companies offer little protection when the skies turn black.

Beware the sham theology of diversification. The mutual fund and financial advisor industries are fee based and love the status quo. Their purpose is to manage the herd, not serve the individual.

Diversification requires the ownership of many mediocre/average companies in order to protect you against the calamity of a crash in share price of any individual stock. But the only reason you would need that protection would be if you loaded up on trash companies to begin with.

I would much rather be limited to investing in only 3 companies of my choosing than required to own pieces of 100 companies of someone else's choosing.

Defining Quality Investing

This is not the place for a lengthy treatise on what constitutes a superior business. There's no shortage of offline and online resources to assist you in developing a foundation for evaluating the prospects and quality of a business if you don't already possess one.

I would suggest that a partial list might include:

Benjamin Graham's classics, The Intelligent Investor and Security Analysis
Warren Buffett's annual Berkshire Hathaway shareholder letters
It's Earnings that Count by Hewitt Heiserman
The Little Book That Builds Wealth by Pat Dorsey
Morningstar website

No single resource is definitive or infallible. As with everything in life, learn what you can, seek counsel, but then make your own choices. It matters less that you and I agree on the value and quality of a specific company than that we each have well-considered arguments to back up our opinions.

In a single, non-quantitative sentence, quality investing is investing in a business that consistently makes a lot of money and one that you're confident will continue to do so well into the future, no matter how ugly or frightening that future becomes.

And rather than trying to quantify that statement with a mathematical or financial formula, let me close instead by asking you two important and revealing questions:

Have you ever sat down and made a list of what you consider to be the twenty best (however you define that term), ten best, five best, and single best publicly traded businesses?
Would your stock selection process differ if, rather than simply typing in a ticker or option symbol into your online trading trading account, you were instead required to meet a minimum $50,000 investment threshold, commit to ownership for at least five years, and submit a lengthy application for review?

Final Thoughts

Finally, not all great companies are readily available at attractive prices (unless they happen to be struggling in the short term). The purchase price of a security, the great value investors tell us, is far more important than the selling price. You can own the greatest company in the history of the world, but if you pay too much for it, you begin your race way behind the starting line.

Fortunately, that's where Leveraged Investing comes in, option trading strategies that can help us mimic successful value investing. That's right - instead of using options with a short term trader's mindset, we can use them to simulate great value investors who buy terrific businesses for less than what they're really worth.

Follow @LeveragedInvest