Value Investing w/ High Quality?

"Value lies in the eyes of the beholder," is a tremendous insight toward further understanding what it means to be a value investor. Often times, I've seen it associated with deeply depressed or "recovery" investment themes, or the famous "cigar butts", which all basically derive their profitable outcome from the avoidance of further deterioration - simply turning the corner, and getting back to break-even. Pardon me for saying so, but that sounds awfully challenging and places such a large emphasis on some type of catalyst taking effect, which is further complicated by the fact that the uncertainty associated with this is extremely high, and one's dependence on coming up with a fair value estimate is as accurate as my jump shot - I don't play basketball. In my previous post, I discussed how value investing (successfully) comes down to a quality estimate of fair value and the discipline and patience to hit your mark when the appropriate margin of safety is in place. If I don't have a good sense of what the investment/company is worth paying for, how could I be any good at finding and profiting from my investment decision, except for good old fashioned luck? I'll give you one exception, which is that there are analysts out there kicking the tires of these companies and traveling to meet with company managers, suppliers, clients, and trying to fit all the pieces of this massive puzzle in place, who might ultimately obtain some kind of informational advantage to which they can lessen the uncertainty of these deep value opportunities, but things change, faster than one can imagine, and the consistency in getting it "right" often times could be attributed to luck - a broken clock is right twice a day.

Enter value investing with a high quality bent. If you've ever heard of Donald and Stephen Yacktman, these guys are basically the poster child of the approach - in my opinion. Nonetheless, I've gained my own personal affinity toward the approach out of my own common sense, and realization that I know what I don't know and what I'm capable and tolerant of doing. So, what is "high quality"? Answer probably depends on who you're asking (as always) but my definition could basically boil down to a few (not exhaustive) of the following: consistency in operational performance - operating margins, return on assets and return on invested capital, generation of free cash flow, payment of dividends and a clear history of increasing them, low business risk/financial leverage, and an economic moat or some kind of competitive advantage. Why does consistency matter? It lessens the amount of uncertainty associated with the company and therefore increases my level of confidence in determining the intrinsic value of the company. Amazingly, these are all things that I can look for with the help of a decent stock screener, and I know that high quality management can be assessed in two ways: qualitatively and quantitatively, so I choose to let the numbers speak for themselves. Keep in mind that I'm not looking at price/multiple ratios, or trying to predict the next couple years of earnings. I'm trying to find the best business first and then I'll go through the process of determining a fair value. Obviously, investing can't be this easy, and things can always change, but here comes the margin of safety to protect me. I'm counting on this discount to cover me from all the unpredictability associated with the company and its future. The greater the uncertainty, the more I'll require, but I'm typically looking for 30%. So what kind of companies am I presently finding today? Here's a short list of some companies that I either own or plan to own (at the right price):

Pepsi, Unilever, Johnson & Johnson, Novartis, Medtronic, Becton Dickinson, Exxon Mobil, Chevron, 3M, Emerson Electric, Graco, Microsoft, and Analog Devices.

Good luck in 2012!,

Dave DeVita, CFA, CFP