Why Price Matters More Than Quality | The Acquirer's Multiple®

During their recent episode, Carlisle, Taylor, and Andrew Wellington discussed Why Price Matters More Than Quality. Here’s an excerpt from the episode:

Andrew: Walmart’s multiple is just exploded upwards. It’s a great company, but what have they done lately? For the last 15 years, they’ve grown their earnings, what, 5% a year? That’s slower than the S&P 500. Costco has been a better company. It’s grown its earnings like 12% a year, but its multiples exploded into the 50s, and you just can’t make that work.

There’s been a defensive shift and you look at some of the food companies or Staples. They’ve got higher than market multiples and they haven’t had any growth for the last 10, 15 years. Procter & Gamble and Coca Cola barely grown their earnings at all and are trading at market premium. So, again, this mega cap phenomenon goes– Magnificent Seven is the bulk of it, but it’s bigger than just the Magnificent Seven. There’s a lot of froth in that space.

Jake: Andrew, what would your counter argument be to the hypothesis that you really want to own quality, especially if maybe you’re going into a downturn economically, which you hear pretty often?

Andrew: So, whenever you say you really want to own quality, as a value investor, you don’t want to think about quality first. It’s always about price. I think Costco is a really high-quality company with really good growth, but I don’t think it’s a good investment at 50 times earnings. So, got downturns. Lots of thoughts about downturns because as a fundamental analyst, as a long-term investor, you got to think about downturns.

I would think we probably think about it more than most other investors, because our average holding period is over seven years. And so, the odds of there being a recession next year aren’t that high. The odds of there being a recession over a seven-year period start to get to be over 50%. So, we’re thinking about downturns from before day one of owning the stock.

Jake: I’m sure you predicted nine of the last five– [crosstalk]

Andrew: [chuckles] Exactly. So, one, if you do the DCF math on a downturn, downturns are actually pretty irrelevant to intrinsic value. That’s not the way the market reacts. Let’s say, a stock’s got a 15 PE and you lose a whole year’s worth of earnings, for one year, earnings go to zero and then they come back. Well, the right value for that should now be 14 times earnings. You just take one point off the multiple. And so, that’s a pretty small change in the valuation of the business and maybe even less.

Earnings don’t usually go down 100%, the financial crisis earnings fell by 30%. So, now, you’re talking about going from 15 to 14.7. That’s again even saying like, was that not even considered? Maybe 15 is the right number, because it would be 15.3 without that.

So, one, market reactions to recessions are way overblown. Our stocks are really unpopular. And so, we do find sometimes they react more severely in the marketplace to a downturn. But if we actually look at how the companies have behaved, our portfolio is less economically sensitive than the S&P 500. You can look at how the companies we own today, of the ones that were public in 2008, 2009, their earnings went down way less than the market’s earnings did. Again, we don’t own those deep cyclicals. We stay away from those things.

We can look at the COVID period, not your typical recession. But even there, we weren’t any more economically sensitive. But you get these knee jerk reactions in downturns. There’s no way to know what the market’s going to overreact to. So, we tend to take the point of view, anything that’s temporary doesn’t count. We just think like, “Okay–” Again, five years from today, if $5 of earnings gets to be $10, we don’t know what path it takes. But as long as they get to $10, we’re okay.”

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