The following commentary is courtesy of Cardinal Capital Management Inc., the sub-advisor for the VPI Canadian Equity Pool and the VPI Canadian Income Pool. The opinions, market outlook, and asset allocation strategies are those used in the design of the mutual funds they manage that we utilize in client portfolios.
What could be more obvious than this Cardinal Rule? For many of the purchases we make in life, quality is an important consideration. But Quality can be very subjective. To some, Harley Davidson and Mercedes-Benz are the epitome of Quality, while other aficionados would swear by Yamaha and Hyundai. So, what does the Cardinal Rule “Buy Quality” actually mean?
In our investment world, Quality is both a quantitative and qualitative concept. First, a company must have a solid history of increasing cash flow, and given their industry sector, must have a very safe balance sheet. Why would someone buy a company that is unprofitable or laden with debt? These factors should be obvious, but we are often amazed at the companies that are perceived as high-quality, despite a sporadic history of earnings or a huge exposure to debt in their capital structure.
If the financial analysis – the quantitative examination – is supportive, then we next consider the qualitative factors, and here is where the creative aspect comes in. Why is the company consistently profitable? What advantage do they have over their competitors that give them a leg-up (think branding like Coca-Cola), or is it something ingrained in the entire industry that makes them all profitable (think of our Canadian banking oligopoly buffered by government regulation). How sustainable is that advantage going forward? This is a key factor of a high-quality investment. Apple, for example, may make very high quality products, but does that necessarily make it a quality company. It is unlikely they will be making the same products in ten years. Will they dominate as they do today, and as Sony did in yesteryear, or will Apple join Sony in the has-been ranks?
Our definition of Quality is not short-term in nature, but is very much a long- term attribute. We want to be owners in companies that we have good reason to believe will still be dominant ten years from now, not just ten months from now. With the long-term sustainability we are looking for comes the likelihood of long-term dividend growth, and as any Cardinal client knows, that is our goal – long-term growth in dividend income. With dividend growth, comes sustainable cash-flows to support client incomes, and as history has generally shown, higher dividends also means more value. More value, sooner or later, means higher share prices. Quality pays.
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