The case for Quality Investing

I have enjoyed reading Nick Sleep’s investment letters. For a long time, these letters were unavailable, but were made public in 2021 on Nick’s Charitable Foundation website. Not well known, he is considered to be among the best investors the world has seen. In 2001, Nick and his partner Qais Zakaria (known as Zak) launched the Nomad Investor Partnership. From 2001 until 2014, they achieved returns of 20.8% per annum in USD compared to global stock markets averaging 6.5% annually. Thereafter they closed the Investment Partnership to pursue more charitable pursuits.  

The key takeaway from my reading was their evolution as investors. Nick and Zak started their fund with large exposures to value stocks - reasonable businesses with low valuations. The idea was to buy cheaply priced companies, then sell if and when the market recognised the rightful worth of these businesses. They would realise their profits and move on to the next value stock. The nature of the business purchased was irrelevant. If the company was trading at a discount to its perceived value, it qualified as a possible investment.

Gradually, however, they began modifying their approach, and started focusing on high-quality companies - companies that could become compounding machines. Companies they could buy, hold, and allow to grow. They realised that creating long-term wealth did not come from buying the cheapest businesses, but rather from investing in businesses that produced the most value over the long run. No matter how cheap value stocks appeared, over time, the high-quality compounders would achieve higher returns. Their strategy worked as their outperformance came from concentrated positions in high quality businesses such as Amazon and Costco.

The high-quality compounders shared similar characteristics. They were able to reinvest profits back into the business at high rates of return, had little or no debt on the balance sheet, operated in industries that were growing, and were run by talented, and ethical executives. It is the investment style that we are following at Sasfin.

The story of Nick and Zak adapting their investment strategy is not unique. Charlie Munger encouraged Warren Buffett to pivot from his strategy of investing in value stocks, and rather to focus on searching for exceptional businesses.

“We’ve really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyse what happened, the big money’s been made in the high-quality businesses. And most of the other people who’ve made a lot of money have done so in high- quality businesses,” said Charlie Munger.

The easing of exchange controls for individuals, over the past two decades, has allowed us at Sasfin to invest clients’ funds offshore, unlocking a universe of opportunities that were once inaccessible. Over time, the structural decline of the South African economy, together with a growing shortage of quality businesses on the JSE, accelerated the need to improve our proficiency in selecting global stocks. Today, our globally diversified portfolios have permitted clients to grow their wealth in hard currencies, to the extent that we now manage more share portfolios globally than we do in South Africa.

We continue to recognise that focusing on exceptional businesses globally provides us with the best chance of creating long-term wealth for our clients. 

The advantage of this approach is that it permits investors to compound wealth over long periods. The fewer decisions they make, the better the decisions become. One does not need to trade weekly or monthly. One simply allows the exceptional companies to do the work over the long-term. It is also more tax efficient in that one only generates tax obligations on sales (which is infrequent) and keeps friction costs low by less frequent buying & selling.

What makes this approach difficult to implement however, is that we function in an environment where the frequency of trading is considered a barometer of a portfolio manager’s involvement.

Bloomberg persistently shows the share price movement whilst interviewing a company CEO. Their journalists, allegedly, are measured on whether the story moves the share price. Frequent trading is like scratching a mosquito bite. It’s comforting at the time, but it is unlikely to give you the best outcome long-term.

There is a belief that if we are not trading, we are not doing anything. This is far from the truth.

Quality investors need to understand why companies can become compounders. In order do this, investors need to identity what a company’s competitive advantage is, why it is durable, and if there are competitors trying to compete this advantage away. This is where quality growth investors should be spending most of their time and energy.

If investors can find these high-quality companies that are able to continually reinvest back into the business at high rates for a long period of time, investors are more likely to achieve their desired investment outcome, even if the starting valuation “seemed” expensive.

Most of the businesses that have durable competitive advantages are found in technology, consumer discretionary, and healthcare sectors.

It makes sense that these three sectors have the highest weightings in a high-quality growth investment strategy.

Just like Nick Sleep and Warren Buffett evolved their investment strategy, we too have done the same at Sasfin - moving from investing on the JSE exclusively, to a more strategic, long-term investment approach with high quality global businesses. These businesses, we believe, gives us the best chance of creating long-term wealth for our clients.