A justifiable but ultimately flawed investing impulse is to rely solely on the numbers we see from a company rather than thinking about the qualitative aspects of the investment itself. Some of this reasonable. Thinking about the quality of earnings is hard whereas current numbers are easy—anyone with an internet connection can pull up a spreadsheet and see Exxon’s $0.63 quarterly dividend backed by profits that are usually 4-5x as much. It’s much harder to look at the quality of those profits—personally, I get excited seeing the fact that Exxon is acquiring 21% more in reserves than it drills out of the ground, and I like to see the company’s slow transition from relying on liberty-suspending-mentally-unhinged third-world despot to do oil business, and shift some of that work to Canada.
My guess is that a lot of this has to do with the unquantifiable nature of earnings quality—okay, we all intuitively know that $1 in profit generated by Coca-Cola is more sustainable than a $1 in profit generated by Best Buy, but it becomes an art form to recognize that Brown Forman has a higher earnings quality than Anheuser-Busch due to unique distributional arrangement, brand equity power, room to run and grow in the future, and brands less susceptible to the current “microbrew trend.”
Good investors will take that information into account in addition to the numbers. When you stare at Anheuser-Busch’s $40 billion debt load as a result of the 2008 takeover, the quantitative and qualitative factors should lead you to prefer Brown Forman to Anheuser Busch if both are trading at fair value and you’re looking to make a 25+ year investment. Of course, Brown Forman is trading at a very high 25-30x current profits right now, so I have no opinion as to whether it will deliver superior returns to Anheuser-Busch at this price point.
When you study quality alongside the numbers, you will look at Procter & Gamble’s 6.5% growth rate over the past five years and recognize that it was built on a flimsy foundation—a lot of it was due to issuing debt to buy back shares and artificially stimulate profits, and other profits were the result of cost-cutting that helped mask market share losses to Colgate-Palmolive, Kimberly-Clark, and the generic competitors (think the Wal-Mart brand versions). Now, one of the best things that Lafley is doing at CEO is re-committing the brand to the quality that earned P&G the sterling reputation it has built over the past century; maybe that means spending an extra $0.25 in packaging here, or spending an extra ten cents to make the Gillette razor less prickly there. If P&G replicated its 2013 strategy for the next four years and only achieved 6.5% growth, I would be much more impressed by it because it was the result of improving and defending the turf, rather than engaging in stop-gap measures in an effort to maintain a linear storyline. Most people you won’t care about studying this difference, but over long periods of time, it explains why Coca-Cola investors get richer and why General Motors investors would have been better off buying a car with their investment capital.