Imagine being tasked with investing the wealth of a family whose future generations depended on it, or a foundation with a critical social mission. Where would you start? You might start with the principle of diversification to reduce portfolio risk. You might also favor high-quality businesses—specifically those that will remain important to the economy and have attributes that help them endure and grow for decades to come. The sensible side of you would want to buy them at attractive prices. We at Clifford Swan would agree on all counts.
If you instead decided to purchase an S&P 500 index fund, you would be relaxing your diversification discipline. As of this writing, about 34 percent of the S&P 500 is weighted to the Information Technology sector. When you include companies like Alphabet, Meta, and Tesla that sit in other sectors but are very much technology-oriented businesses, the S&P’s effective technology weighting exceeds 40 percent. Technology is an area of the market that capitalizes on innovation and produces some excellent long-term investments, yet it is sensitive to unpredictable winds of change. Concentrating a portfolio in any one sector, even technology, introduces risk.
“When you include companies like Alphabet, Meta, and Tesla that sit in other sectors but are very much technology-oriented businesses, the S&P’s effective technology weighting exceeds 40 percent.”
By investing in a market index fund, you would be glossing over your valuation discipline as well. By some measures, the S&P 500 trades at valuations far above its historical average. Statistically, current valuations sit about 3 standard deviations above the mean, which happens less than one percent of the time. Over long periods, higher starting valuations often lead to lower returns.
“Statistically, current valuations sit about 3 standard deviations above the mean, which happens less than one percent of the time.”
And yet, index funds have become the default choice for many institutional and retail investors. Amid such an environment, we’re increasingly asked to explain what we seek in the companies we invest in, and how we go about finding them at reasonable prices. Our response has been that we look to three “must-haves.”
Three Requirements for Quality Investment
First, we seek out businesses with high or increasing returns on the capital invested in it. This is the signature sign that the company may be competitively advantaged versus its peers. As markets are fiercely competitive, any business earning high returns becomes a target for others attempting to compete those returns away. Rising or persistently high returns on capital indicates there might be something special keeping competition at bay.
“Rising or persistently high returns on capital indicates there might be something special keeping competition at bay.”
Second, we try to find businesses that can reinvest profits to grow. This can be surprisingly difficult for highly profitable companies, as they are often in the mature phases of the corporate lifecycle. But companies that are both profitable and able to reinvest those profits—examples might include distributors with the potential to move goods to more locations, or semiconductor companies producing new, innovative chips—allow us to benefit from a long runway of future growth. Moreover, a focus on growth via reinvestment helps us steer clear of business attributes that can get investors into trouble. Profitable companies that can reinvest often don’t need to raise debt that might increase the riskiness of our investment, or additional equity that might dilute our ownership stake.
Third, we like to see multiple stakeholders winning together. We believe that if a business’s customers, suppliers, employees, management, and shareholders all benefit simultaneously, the effect will be a business more likely to stand the test of time. Such alignment maximizes the odds of long-term success and creates a positive-sum game (i.e., growth for all) instead of a zero-sum game wherein conflicting priorities may interrupt value-creation.
“We believe that if a business’s customers, suppliers, employees, management, and shareholders all benefit simultaneously, the effect will be a business more likely to stand the test of time.”
Certainly, there are many other characteristics that we like to see. We’re fans of pricing power, industry leadership, and a host of other boxes that quality-focused investors check. But we’ve found that these are just symptoms of the presence of one or more of our “must-haves.” If our three most important criteria are met, we’re confident we’ve found a business that grows in value over time, such that a long holding period works in our favor.
Solving the Sensible-Price Problem
While identifying high-quality businesses is paramount for us as long-term investors, finding them in the market at sensible prices is critical for strong returns. Such opportunities can appear due to structural limitations that many market participants face. For example, many institutional investors follow a mandate to closely track their benchmark’s sector weightings—a behavior often referred to as “hugging the benchmark.” In essence, their analysts will spend disproportionate amounts of time looking at and recommending companies in the largest sectors (today, these are the Information Technology and Financials sectors) even if those holdings do not look attractive on a standalone basis. In the process, these same analysts overlook opportunities in sectors that aren’t well represented in the index yet are very compelling.
Another way that high-quality businesses become attractive and available to us is from the rise of short-term focused hedge funds. These firms build their strategies around predicting quarterly results or other events. Growth of these short-term oriented funds has been strong over the past decade, to the point where they now comprise more than a quarter of the hedge fund industry’s holdings in U.S. stocks. Often, hedge funds are quick to exit positions when companies miss quarterly estimates or stumble for reasons that might be temporary in nature. This creates an opening for long-term investors to buy.
“We are unwilling to sacrifice long-term profitability and an attractive reinvestment runway for the chance to make a quick gain.”
Ultimately, our goal is to protect and grow wealth for the long run. Determining what we want in the companies we invest in and how we find them simply involves trade-offs in pursuit of that goal. We are unwilling to sacrifice long-term profitability and an attractive reinvestment runway for the chance to make a quick gain. Meanwhile, we are willing to shoulder the discomfort of looking different from the market and our peers, and to lean into companies with challenges we deem transitory, in pursuit of long-term value creation. Our strategy has worked for us and our clients for years, and we believe it remains timeless.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.
