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Balancing Asset Quality with How Much to Pay


In business and investing, a bright line is often painted: on one side of the line are those who like to pay a cheap price for a company; on the other side of the line are those who like companies that grow a lot.


Both perspectives are valid but it’s an artificial line. Pay a low price for a bad business = poor result. Pay too much for any business = poor result. Known price today versus future unknown result. What determines future result? The cash flows generated by the company. And what determines the durability of those cash flows? Business quality.


Business quality can be defined in many ways but it basically boils down to the degree to which future cash flows are durable, persistent, and increasing.


Price paid today (lower is better) relative to business quality (higher is better) is the critical assessment. From Southeastern Asset Management’s Staley Cates(1):


“I would reiterate the old thing, price matters. People don't think it does because they've been bailed out for 10 years with cost of money going to zero. You could be wrong assessing your moat and your franchise. You could be wrong on what you thought the company's earnings were going to do. But you were often bailed out by the multiple, which has been the inverse of interest rates…


…what gets lost in the shuffle is we have a nuance or a balance. On the one hand, we stress that price matters. We are one of the few people left exercising a very strict value discipline. But the balance is because all of our own money, and our foundation’s money, is in these funds. Quality matters deeply to us.


The reason price still matters is because price is the inverse of future return based on a set of future cash flows.


The reason quality matters is because quality determines whether that set of future cash flows will be there or not.”


As much art as science, finding the right balance between price and asset quality is the essence of how to generate high returns on capital. That’s true when investing in new internal business projects, and it’s true when acquiring other businesses.


Price matters. Asset quality matters. Both should be top of mind as you evaluate your next opportunity.

 
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