Some of the main reasons that most investors shy away from owning quality stocks are:
1. Quality stocks are large cap stocks, hence have slower growth.
2. Quality stocks are normally priced-in.
3. Quality stocks are only suitable for large capital.
Before we go in and clear up these misconceptions, it is useful to define what quality means. Here, quality simply means stocks that can generate a high return of capital for a certain amount of period for the owner/shareholders. Or in financial term, the wideness of the gap between ROIC (Return on Invested Capital) and CoC (Cost of Capital), and the length of that gap i.e how long can the company sustain this abnormal return?, these 2 things determine the durability and the moat of a company, and its quality.
The 1st assumption for not owning quality stocks because they tend to be large cap stocks i.e Public Bank, LPI etc. And large cap stocks tend to have slower growth compare to small cap stocks. This assumption make sense because when someone says quality, we associate that with a great long-term track record. And companies that have long-term track record tend to be large cap. But quality has nothing to do with market cap or the size of the company. Moat can exist in small cap stocks just as they can appear in large cap stocks. This is one of the reason people tend to think you can only find high quality stocks in US but not Malaysia. Yes it is true that Malaysia is a way smaller market than US, so in that sense, there are less quality stocks. But since quality is not tied to the size of a company, you can still find a handful of quality stocks in small-mid cap universe.
And large cap stocks doesn't necessary mean slow growth. If I tell you a company has annual sales of $10 bil, can you tell whether the growth rate is fast or slow? You can't without knowing the TAM (Total Addressable Market). A company with $10 bil in revenue can still grow at 15-20% if the TAM is $10 trillion. And take LPI Capital. LPI's revenue growth rate is around 9.6% over the last 10 years. That is not exactly exciting in the era when many makes 100% on Hengyuan in 3 months. But if you hold it over the past 10 years, you would have achieved a CAGR of 18.2%. That is by no any mean slow growth.
It is also common to hear that most quality stocks are priced-in. But let's do a thought experiment and turn this around, if you know which quality stocks are priced-in, and which are not, that means it is also likely that you know that which non-quality stocks are priced-in and which are not. In that case, why own mispriced non-quality when you can own mispriced quality stocks?
And most people assume quality stocks are priced-in because they command a high P/E ratio i.e 20-30. This misconception fools many people into thinking there are a lot of undervalued stocks with low P/E ratio than there actually is. This misconception is part psychological, part linear thinking.
Psychologically, we tend to overestimate near term and underestimate long-term. Recency fallacy. We put more weight on what has just happened. It is also partly because of bias towards action over inaction. So when a low P/E stock has a jump in 2 quarterly earnings, it is easy to concoct a story why it is undervalued.
The same applies to quality stocks. This is also where linear thinking kicks in. If a stock can grow at 10%, generate 10% ROIC for 10 years has a market PE ratio of 10, what PE ratio should a stock with 10% growth rate @ 20% ROIC for 10 years deserve? Most would say P/E 20 is fair, but it isn't. The fair P/E would be closer to 55.
These factors are what cause most people to underestimate owning quality stocks (and overestimate cheap stocks).
The final misconception is quality stock is only for people with large capital, referencing to Warren Buffett as he move away from Ben Graham style to Munger style. That is true but I don't see why investors with smaller capital shouldn't own quality stocks. At the end of the day, what matters is your long-term CAGR. If a portfolio with quality stocks can give you long-term CAGR of 15%, you better make sure owning a portfolio of cheap stocks with more frequent buy and sell can achieve a minimum CAGR of 20%.
I have gravitated towards quality stocks over the years not because I have a large capital. But because there is so much leverage to own them. When you own cheap stocks, you have to do all the due diligence yourself. Whether that is from making sure it is indeed cheap, what you think should happen will happen, to constant monitoring for any changes in business risk and searching for new ideas after selling when it reaches fair value, you have to have every tailwind. And if you have done well doing this over the past, you've my deep respect.
The leverage for owning quality stocks come from the moat itself. The moat and the management does the heavy lifting in the long-term even if you're wrong in your judgement. I shifted my portfolio from cheap stocks to quality isn't because my investing skills have improved remarkably, but because I overestimated my ability to pick cheap stocks in the past.
This writing is by no means that owning quality is the only way to go. The best strategy is going to be one that align with your lifestyle, whatever that is. But hope this should clear up some misconception about quality stock.
https://klse.i3investor.com/blogs/JTYeo/212197.jsp
