As stock pickers, we see equities as economic interests in actual companies — and high-quality businesses garner our attention. We concentrate on small- to mid- cap companies that we think can grow over time and seek to purchase them at a discount to our estimation of their economic worth.
Ever since Fenimore Asset Management, the independent investment advisor to FAM Funds, was established in 1974 we have focused on long-term, value investing. Our genesis came from the sale of a high-quality, successful, family business. We invest in companies that exhibit those same top-notch characteristics because it’s our experience that these enterprises can perform well in growing, stagnating, and declining conditions.
As of June 30, 2014, the U.S. stock market, as measured by the S&P 500 Index, had increased for more than five consecutive years since its March 2009 trough. Meanwhile, given the severity of the economic environment, the Federal Reserve reduced interest rates to unprecedented levels and has maintained them for a record-setting time. This combination of events has led to an interesting performance contrast in the stock market between high- and low-quality companies. An analysis of the S&P 500, Russell Midcap, and Russell 2000 indices reveals that low-quality stocks have outperformed considerably during this Bull Market.
We define high-quality businesses as those with high profitability (high return on equity and profit margins), low debt, and the ability to generate free cash flow. Conversely, low-quality companies have low profitability, much debt, and little cash generation.
During the stock market’s initial rebound, a large number of the riskier stocks that performed the worst during the Bear Market did the best — this is typical. Even though the survival of many corporations was questioned due to precarious financial footings, their stocks boomeranged as fears abated.
However, well after the initial run-up, low-quality stocks have continued to outperform. Although unusual, this scenario makes sense for two reasons:
1. The extended “easy money” environment has allowed flatlining companies to breathe new life because the cost of borrowing is reduced when they refinance; this makes bankruptcy a remote possibility. Consequently, investors “re-rate” the equity and low-quality loses its “Scarlett Letter” — a paradigm shift that would have been unthinkable 10 years ago.
2. Sustained low interest rates have driven numerous investors to chase returns in areas such as high-yield bonds, sub-prime auto loans, and speculative stocks in hopes of producing income. This “search for yield” has provided needed liquidity to many fragile businesses.
Rock versus Sand
To be clear, both high- and low-quality stocks have benefitted from the post-fiscal crisis environment. However, at some point in the future we do know that interest rates will rise, borrowing will become more expensive, and there will be less liquidity in the system. Therefore, the essential question for investors is, “When the music stops, do you want to have your hard-earned money invested in a company built on rock or sand?” Beyond that, “When the storms come, do the businesses you rely on for your financial future have a solid foundation?”
During times when the value of a high-quality enterprise is not reflected in its stock price, our patience can be tested. Nonetheless, Fenimore’s confidence is tethered to compelling historical data that reinforces our conviction that buying undervalued equities of superior companies succeeds in the long run.