Over a long enough timeline, every quality company faces a reckoning.

According to Bloomberg data, only two of our current holdings – Costco and Fastenal – have not suffered a 30% or more sell-off (or “drawdown” in industry parlance) at some point in the previous decade. And even those two fell by more than 20% at some point. Netflix fell an astounding 80% in 2011 during its bumpy transition from DVD to streaming video.

While we didn’t own all these companies during their drawdowns, it’s a good reminder that the market can offer wonderful buying opportunities on high quality businesses. The catch is that sometimes a sell-off is justified and it’s not obvious in the moment what the right move should be.

Here’s how we think through the issue.

Quality companies tend to carry premium valuation multiples. The market is right to have lofty expectations for companies with attractive growth prospects and high returns on invested capital.

The moment those expectations are challenged, however, investors typically sell first and ask questions later. This action is not always irrational.

Research done by Credit Suisse HOLT looked at the performance of different investment styles across the largest 1,800 global companies between 1990 and 2014. The “best in class” group – those companies scoring in the top 40% of the sample in HOLT’s quality, momentum, and valuation metrics – was the best performing cohort.

Sounds good for quality, right? However, the second-worst performing group of the nine studied were “quality traps” – companies scoring in the top 40% in quality, but in the bottom 40% in the momentum and valuation metrics. Quality traps stay expensive as their fundamentals deteriorate. This cohort’s performance only just eclipsed the “worst in class” group, which ranked in the bottom 40% in all categories.

Put another way, the quality factor has a wide dispersions of outcomes. If you pay for a ruby but get a rhinestone, you’re not going to have a good outcome. And in the market, you don’t know for years if the ruby you paid for is actually a ruby or a rhinestone. Therefore, at the faintest hint of rhinestone, the market reacts sharply against ruby-priced businesses.

No one wants to own a quality trap, but these drawdowns in quality companies also present opportunities for investors who have conviction in the strength of the underlying business.

How might we do that? Let’s start with what the market is telling us when a company’s stock has a big drawdown. It’s saying the company’s future cash flows will be lower than what the market price suggests or the risks associated with those cash flows are underappreciated.

Here’s how our investment philosophy – anchored in moat, management, and forecastability – is designed to respond to such challenges.

First, a moat allows a company to sustainably generate ROIC above its cost of capital and produce more distributable cash flow for a given level of growth. Having a deep understanding of the company’s moat sources helps us evaluate the impact of the event on the underlying business. If we conclude the moat is intact despite new information dragging the stock lower, we’ll be more likely to hold – or even buy more.

Moats also give management teams time to respond to new challenges. But what management does with that time is critical, and especially so in a pinch. If they are poor capital allocators, have too much debt, or oversee a bland or even destructive corporate culture, a crisis will only exacerbate those issues and the moat will erode. As such, we aim to avoid low-caliber management teams.

Finally, the better we understand the company’s unit economics – how the company turns revenue to profit for each unit sold – and its key metrics for success, the more likely we are to recognize material versus transitory impacts.

To illustrate, shares of Masimo declined almost 30% from January to early June this year. Having built conviction in Masimo’s moat and management and understanding its business strategy, we confidently increased our position during that time. It’s still too early, of course, to determine if that was a wise move or not, but the drawdown never caused panic on the team.

On the other hand, we exited our position in Prestige Brands (now Prestige Consumer Healthcare) in May 2018 after a protracted sell-off in the stock, which we’d used to slowly build a position in Prestige. Even though the stock appeared “cheap” on a price/earnings basis when we sold, our conviction in the company’s moat withered as it became clear that bargaining power lay with the products’ distributors rather than at Prestige. Since we exited, Prestige shares have underperformed the S&P 500 on a total return basis (as of July 19, 2021).

Once we lose conviction in a company’s moat, management, or forecastability, we exit the position. Others might successfully invest in “turnaround” businesses, but it’s not the game we play.

All quality companies have large drawdowns at some point, so we as long-term investors should be ready for such occurrences. The less we allow price swings to determine the narrative and instead focus on core business performance, the better our long-term investment performance should be.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.