In my earlier article, I showed that growth in net worth of nonfinancial corporate businesses have grown very much in lockstep with the growth rate of S&P 500 index’s price between 1945 and 2014. Over this timeframe, net worth of nonfinancial corporate businesses in the US grew at a CAGR of 7.1% with S&P 500 index’s price growing at a CAGR of 7.2%. It is important to note that this 7.2% return is the geometric mean of the S&P 500 yearly returns between 1945 and 2014. This of course doesn’t mean that S&P 500 had a return of 7.2% in each one of those years. Much like any average, it lumps together numbers that were well below it as well as numbers that were significantly above it.
Figure 2 below shows the distribution of S&P 500’s yearly returns between 1880 and 2013. As can be seen, there were several observations that were in the negative territory. Similarly, the annualized 7.1% growth in net worth of nonfinancial corporates doesn’t mean that every business grew at that pace. While there were several businesses that managed to grow at significantly higher pace, there were several others that grew at much worse rates.
Figure 2: Distribution of S&P 500 Price Returns
Further, in that same article, I asserted that over the long-term, price growth of a portfolio of equities approximates the underlying business value growth of the businesses included in the portfolio. From that assertion, it can be deduced that an investment process that successfully identifies businesses that are able to grow their underlying business values at above average rates over extended periods, should generate superior long-term investment returns. The key is to be able to identify businesses that are to the far right of the underlying business value growth distributions and have the ability to stay in that zone.
It is important to understand that a business that is able to grow its business value at rates well above the average, is enjoying some sort of a “competitive advantage” at that point of time. However, the ability to stay in that zone depends on the “sustainability” of that competitive advantage.
Therefore, a simple way to enhance investment returns of a portfolio over the long-term is to invest in businesses that have the ability to grow their business values at above-average rates in a sustainable manner. Such businesses possess significant competitive advantages that are sustainable. At Multi-Act, we refer to such businesses as High Quality (HQ) businesses and we further posit that High Quality is a distinct investment style.
 Warren Buffett has over time indicated this to be the best investment strategy through several of his quotes. Some of his quotes that suggest HQ as an independent investment strategy are: i. “Time is the friend of the wonderful business, the enemy of the mediocre”. ii. “Both our operating and investment experience cause us to conclude that turnarounds seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.” iii. “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”.