High-quality companies can generate substantial investment gains for investors. Unfortunately, quality companies also suffer from two shortcomings as investments: companies fail to sustain excellence in perpetuity and stocks of excellent companies get bid up in price to reflect their quality, thereby reducing future expected returns.

The conundrum for investors these days is the trade-off between the value of quality and price to pay for it. While humanity might have learned to live with COVID, there are plenty of other challenges ahead: evolving customer preferences and buying habits; rising materials and labour cost inflation; growing geopolitical tensions; increasing regulatory interventions; and so on. Historically, quality companies have adapted effectively and evolved appropriately during difficult business conditions, turning challenges into opportunities. However, quality companies have broadly been bid up in price over the past decade and notably during 2021.

For example, UK-based Halma has been an effectively managed manufacturer of products that help their clients make the world cleaner, safer, and healthier. Halma has also been a proficient acquirer and operator of companies. Over the past ten years, Halma has grown its earnings at about 12% per year, including during the very difficult COVID-challenged 2021. Notably, given the novel challenges, pandemic-related business disruptions served to illuminate the value of Halma’s value proposition to customers. In 2021, the company was named one of Britain’s Most Admired Companies. Concurrently, the market has recognized Halma’s quality. During the past decade, Halma’s earnings per share increased 3x while Halma’s stock price increased 6x—including a 33% return in 2021—materially outpacing underlying earnings growth.

Quality companies tend to share common characteristics. They possess clear competitive advantages that differentiate them from competitors; add significant value to their customers; reinvest effectively to continuously improve their products and services; conduct their business with integrity toward other stakeholders such as communities they operate in and people they employ; all while also growing profits for the owners of the business. However, quality could also mean different things to different people. Perception of quality might be further influenced by psychological factors, including how cautious or optimistic people feel in the moment, and even price itself. It is common knowledge among marketers, for example, that many consumers associate high price with high quality, and vice versa. Generally, though, it’s not the quality itself but the lack thereof that becomes apparent in hindsight.

Sustainable quality is rare. It takes adept leadership to combine the basic building blocks of labour, capital, and innovation into solutions and experiences for customers by way of strategy, execution, and capital allocation, thereby generating attractive returns for investors. While effective leadership can be taught and learned in theory, in practice few companies can boast a series of successful successions of CEOs, and financial history books are littered with stories of great companies that stepped into their own graves, often due to misguided strategies and misplaced focus.

In his classic book Good to Great, Jim Collins summarizes common success factors of high-quality companies that consistently outperform within their respective industries. These include having the right people on the bus, focusing on their circle of competence, fostering a culture of discipline, promoting facts over fantasy, and investing in technological innovation. Common-sense advice? Sure, but the tremendous irony of the Collins study is that since it was initially published in 2001, the companies in his “great” category have almost universally failed to sustain their greatness for long, even when armed with his ingredients for sustained success. Notable failures include Wells Fargo, which subsequently resorted to widespread cheating of its customers, retailer Circuit City, which entered bankruptcy less than a decade later, and the failed mortgager Fannie Mae, which famously required a substantial government bailout during the global financial crisis. Sustainable quality tends to be apparent ex post, but rarely ex ante.

Beyond the bankruptcies mentioned above, quality companies can also turn out to be poor investments … and not just over short periods of time. Nifty Fifty stocks offer cautionary lessons. The Nifty Fifty was a group of 50 quality/growth stocks in the 1950s-1960s, including many which remain household names today: Coca-Cola, Avon, McDonald’s, Texas Instruments, IBM, Black and Decker, Johnson and Johnson, Baxter, Schlumberger, Gillett, Kmart, etc. These stocks generated substantial gains for investors during the 1960s on the back of strong growth and expanding earnings multiples. In 1972, P/Es for the group ranged between 30-90x, with McDonald's, Disney, and Polaroid each trading over 80x. However, during the 1973 stock market crash, Nifty Fifty stock prices fell much more than the market in aggregate—not due to fundamental declines in their businesses, but primarily because of a derating in price investors were willing to pay for their earnings. Many Nifty Fifty stocks declined 60-80% as a result, including McDonald's, American Express, Xerox, and Disney over the subsequent two years. Arguably, an apt comparison to today’s market.

Our story of Halma could be an example of how one could improve the odds for successfully investing in quality companies. Our team invested in Halma in 2010, when the company exhibited clear signs of quality and operational excellence. Halma even managed to grow their profits during the global financial crisis. Moreover, the stock was attractively priced relative to our estimated discounted-cash-flow based fair-value range, and trading at 11-12x P/E at the time. Yet, the market was seemingly interested neither in Halma’s quality nor its attractive price, but Halma’s perceived lack of cyclical recovery “torque”—or stock price upside gearing, as the investment brokerage industry tends to put it and frequently prioritize. While the market was preoccupied with factors other than Halma’s quality, we chose to invest in the company because we had followed it for a number of prior years, had multiple meetings with senior management, and we were interested in Halma as an investment for the long term.

At present, companies face a plethora of meaningful challenges across economic, geopolitical, social, technological, logistical, healthcare, and environmental factors, to name but a few. Historically, the best-managed quality companies tended to adapt and evolve more effectively in times of great change. It is up to investors to recognize these quality companies early enough—and remain disciplined in paying a stock price that is reasonable relative to the value—in order to achieve satisfactory investment returns.