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The Value of Quality

Volume 75, No.2

“I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things.” - Benjamin Franklin

Superior quality should command a premium price; most would agree with this basic premise. But how do consumers value quality and what price are they willing to pay? Although value may drive price, the two are not synonymous…price is given and value is received. Consumers are most satisfied when they receive more value than they pay for. Their goal, therefore, is to pay a price equal to or less than the value they estimate they will receive from the product. The challenges involved in estimating quality value often prevent consumers from realizing this goal.

Products can be dissected into three value components; a base and two distinct premium components. The “Base” component is the value received from the competing product of average quality. The “Quality Differential” premium component is the value received from superior performance and/or durability (above and beyond the basic product). The third component, “Brand Equity” premium, is the value received from the product’s brand image. Brand equity is intangible and adds value to a product because it makes consumers feel good about their purchase. The sum of the three components equals the total value of a product.

How do consumers reconcile the differences between quality value and price? First, they identify the price premiums. In 2003, Apelbaum, Gerstner, and Naik (AGN) published “The Effects of Expert Quality Evaluation Versus Brand Name on Price Premiums”, in The Journal of Product and Brand Management. An objective of their study was to determine the price premiums that national brands receive as a function of their objective quality differential.

AGN gathered prices for 755 frequently purchased grocery brands from 78 product categories. Utilizing “Consumer Reports” experts, they were able to compare the prices and quality of “national” brands to “store” brands within each category. They quantified that, on average, a national brand product of superior quality sold at a 50% total price premium. They also discovered that this premium was attributable to both a quality differential and brand equity component.

Next, consumers estimate value received from the premium components. Estimating the Quality Differential premium is straightforward. Performance and durability are tangible, and therefore, they can be measured and valued. As long as the superior performance and/or durability of a product remain constant, so will the value of its quality differential. The real challenge, however, stems from the nature of the Brand Equity premium. Brand equity is dependant upon consumer attitudes and how people feel about certain products. Consumer attitudes change…and as they change, so do Brand Equity premiums. If brand equity diminishes over time, consumers find that they gave too much weight to the value of the premium and thus, paid too much. While fluctuations in Brand Equity premiums may disappoint consumers, it can also present them with opportunities. When the general consensus regarding the brand image of a product is low, the manufacture may place the product on sale to promote purchases. Consumers, who still see the premium value of the product, will make a purchase. This enables them to purchase a quality product at a bargain price, or discount to actual value.

This is how we invest your assets.

Our Investment strategy is similar to bargain shopping. Buy quality companies when they are on sale or “trading at discounts to actual or intrinsic value”. Executing this strategy is not so simple. Valuing quality companies takes hard work, thorough analysis, and patience. Historically, high quality investments such as General Electric or Johnson & Johnson have traded at premiums compared to the average company. Premiums arise because these companies possess long-term sustainable competitive advantages that enable them to generate above average free cash flow growth, high returns on capital, and superior financial strength.

If quality companies historically trade at premium prices, how and when do we purchase them at discounts? We wait patiently for them to go on sale. Over time the total price premium, at which quality companies trade, fluctuates. When the total price dips below a company’s intrinsic value, we make a purchase. We can utilize the consumer price-value component framework discussed above to explain.

Our investment process, which is governed by four investment tenets, is designed to identify quality companies. Only 200 of the 10,000 plus publicly traded companies meet our quality criteria. We chose 20 of these companies and measured their price premiums over the 20-year period from 1987 thru November 2006. The purpose of our study was to answer the following questions:

• What is the average quality price premium?
• Does the quality company price premium fluctuate over time…why?
• Do quality companies go on sale…when are they trading at discounts?

We utilized the S&P 500 index, which encompasses 75% of the market value of the U.S. equity universe, as our comparative or “Base” investment (i.e. the “store” brand). We chose P/E ratio, or the current share price divided by 12 month trailing earnings, as our price metric for two reasons. First, P/E ratio indicates what the market is willing to pay for each dollar of earnings a company generates, thus it normalizes prices for comparability. Second, the broader market focuses on Price to Earnings (P/E) ratio. The quality price premium/ discount was calculated by comparing the average P/E of the quality companies to the average P/E of the S&P 500.

What is the average quality price premium?

Historically, quality stocks trade at a premium to the average company in the S&P 500. The average annual P/E ratio of the 20 companies in the basket is 26.28 versus 22.55 for the S&P 500. This suggests that over the last 20 years, quality companies have traded at a 17% price premium to the average company in the S&P 500.

Does the quality company price premium fluctuate over time…why?

Yes, the price premium consistently changes over time. While the 20-year average premium was 17%, there were years and periods when the premium was demonstrably higher or lower. At the end of 2000, for example, the quality premium reached 42%, or 25 points higher than average. Company value did not justify the outlandish price premiums and investors who initiated positions at this level watched their portfolios decline soon thereafter. But, these investors were given a warning… one that occurred 30 years earlier.

The Nifty Fifty was a group of high flying quality growth stocks that soared in the early 1970’s only to come crashing down in the 1973-1974 bear market. Among these 50 companies were Xerox, IBM, Coca-Cola, Walt Disney, and GE. In fact, half the companies in our list were Nifty Fifty members. At its peak in 1972, the Fifty had a P/E ratio of 41.9, more than twice the 18.9 offered by the S&P 500. But when the bear market struck in 1973 and the S&P lost half its value, the Nifty Fifty lost an average of 62%. The elevated P/E premium was simply unsustainable. Investors paid too much for the value received.

What causes fluctuations in the quality price premium?

In his book, Irrational Exuberance, Yale professor, Robert J. Shiller, described the market mayhem of the late 1990’s. He wrote, “Investors, their confidence and expectations buoyed by past price increase, bid up stock prices further, thereby enticing more investors to do the same, so that the cycle repeats again and again, resulting in an amplified response to the original precipitating factors.” Investor attitudes change quickly when they see their neighbors getting rich. To alleviate the fear of “missing-out” they join the crowd, even when prices rise beyond reasonable value. This demand driven price premium growth is similar to the “Brand Equity” premium found in consumer products. Both are driven by human attitudes and/or feelings, that often change and lead to miscalculations in value.

When do quality companies go on sale…when are they trading at discounts?

The same amplified brand equity-like response that leads to elevations in quality price premiums, also leads to deflation as well. This results in periods when prices are lower than quality company value. In late 2000 and early 2001, investors saw opportunity in the lesser quality commodity investments, including oil and material stocks. The herd fled from our quality companies and into commodity stocks. The lack of demand for quality led to a descent in the average price premium of our 20 companies. In 2002, investors could have purchased the 20 superior companies at a 10% discount to the S&P 500.

Shopping for quality products and investing in quality companies are two very different activities.

Both consumers and investors, however, can take advantage of similar value seeking strategies. And if these strategies are executed properly, consumers and investors can avoid the heartache that results from paying too much. More importantly, the strategies enable consumers and investors to take advantage of the opportunities presented when quality value is greater than premium price.

Like consumers, the most satisfied investors receive more value than they pay for. And while changes in investor attitudes cause the prices of investments to move up and down, they observe. When prices are greater than company value, they wait patiently. But when prices fall below company value...they buy.

Quality companies have histories of superior operating performance. Investment Counsel has a long successful history of purchasing them for client accounts. Fortunately for us, other investors from time to time grow bored with quality companies. This provides us our opportunity to purchase at a discount. As of October 31, 2006, the 20 company quality basket was trading at a 1% premium to the S&P 500, well below the historical 17% level. The last time this occurred was in the early 1990’s and patient investors who bought then were richly rewarded. Bargain shopping consumers would tell us that right now, quality companies are on sale.

We agree.