Buy Quality
BY JEFF RANCE , CFA
One of our core investment rules is Buy Quality. “Quality” does not mean buying companies that looked good in the past. It means buying businesses that can remain durable and grow over time. In financial jargon, this is known as the “terminal growth rate”.
Bear with us, but the way to frame this is with some math. A common way to evaluate companies is through a discounted cash flow model, or DCF. The formula looks something like this:
EV = FCF₁/(1 + r)¹ + FCF₂/(1 + r)² + … + FCF₅/(1 + r)⁵ + (FCF₆/(r − g))/(1 + r)⁵
While it looks complicated, it is relatively straightforward. The “FCF” are estimates of free cash flow over the coming years. The “r” is the discount rate or the returns required to compensate for certain risks and uncertainties. The “g” is the aforementioned “terminal growth rate”. It is an estimate of the rate at which a business can continue to grow well into the future. It’s but one little piece of the formula, but it carries a lot of weight. For a company growing 10% per year over the next 5 years, the terminal growth rate accounts for the majority of a company’s value. Small changes have a huge impact: a company is worth 25% less if the terminal value declines from 3% to 1%. Getting this right is hugely important. A common pitfall is that a company can have excellent historical results and look fine over the medium term, but if its long-term prospects are deteriorating, it may be overvalued. What happens in the long-term is what matters, and this is what quality means to us.
Technology markets today show this clearly. The AI buildout has increased confidence in the long-term cash flows of the infrastructure supporting the data center buildout, including companies such as Applied Materials, Broadcom, and Cummins. At the same time, AI has raised difficult questions for software and information-services businesses. These companies still have attractive near-term outlooks; however, the ongoing improvement in AI tools, particularly coding, raises questions about terminal value. Can customers build these products and services internally? Will this lower barriers to entry for new competitors? Will margins erode from the adoption of AI within these businesses?
Not every challenged company is doomed. Some will adapt and become stronger. Others will not. The point is: quality is not permanent. It’s our job to try to answer these questions to determine if the quality of yesterday will persist into the future.
