This article was first published in the National Post on July 23, 2022. It is being republished with permission.

by Tom Bradley

You may have heard investment managers talk about “high grading” a portfolio. They’re likely referring to the idea that there’s an opportunity to increase the average quality of your holdings in a market where all stocks are down. The implication is that the market isn’t differentiating enough between the strong and weak and, as a result, there’s little or no valuation gap between high-quality companies and their weaker brethren.

High grading has an intuitive appeal. Leading companies that have strong balance sheets can maintain their profitability in a slower economy, and are able to be countercyclical when others can’t. They can raise money at reasonable rates, even if they don’t need it immediately. They can hire great people when bonuses are down and stock options are worth less. They can expand when engineering and building costs are lower and less disruptive to their business.

And, like a good investor, they can provide liquidity when others desperately need it. That means buying a competitor when few if any bidders are at the table, or acquiring products, facilities and customers for pennies on the dollar.

A great way to build wealth is to ride what I call the “super compounders,” companies that come out of each down cycle stronger than they went in. In Canada, I’m talking about the likes of Premium Brands Holdings, Ritchie Brothers Auctioneers, Constellation Software, Canadian National Railway and Franco-Nevada.

The list from south of the border is much longer and would include Visa, Danaher, Coca-Cola, Procter & Gamble, tech giants such as Apple, Alphabet and Microsoft, and, of course, Warren Buffett’s company, Berkshire Hathaway.

There are definitely times when quality is on sale and I like the strong-get-stronger strategy, but the execution is more nuanced than it sounds. The price of highly profitable, well-financed companies may be down, but not by as much as the speculative stocks that got crushed. This year, for instance, companies that are struggling to achieve profitability and/or highly levered are down far more than the overall market.

Also, success is highly dependent on the length and depth of the economic malaise. Since the financial crisis in 2008, setbacks have been brief, with the United States Federal Reserve and other central banks coming to the rescue with lower interest rates. The economic declines were modest, and investors knew the Fed had their back.

In short and shallow slowdowns, everyone lives to fight another day and the biggest moves off the bottom are stocks that were left for dead. The quality stocks that held up better also rebound, but don’t have as much recovery potential.

It would appear the economy is now in decline. If this slowdown is severe and drags out (that is, a recession), the weaker players may not survive, and those that do will be at the mercy of investors when they need to recapitalize. If they can issue more debt, the interest rate will be higher, and any equity raises will be at lower prices, which will cause severe dilution for existing shareholders.

To build a portfolio of leading companies, there are things you must do. You need to watch that their greatness is sustainable (and hopefully expandable), be careful you’re not paying too much, and be prepared to stay patient when other companies are in vogue and roar ahead.

At this stage of the current cycle, investing in the strongest companies may maximize your returns over the next few years, but there are two huge benefits even if it doesn’t.

First, the risk of permanent capital loss diminishes when paying a reasonable price for companies that provide something that’s sure to be needed in five years and are likely to have a stronger competitive position after the slowdown. Some purchases may prove to be early, but you know you own a valuable asset.

Second, it helps you deal with the emotion and risk aversion that get in the way of making sound investment decisions. Like everyone, you want to take advantage of periods of market weakness, but it’s extremely difficult to do when your portfolio is down and the economic outlook is grim. Buying bulletproof companies makes it a little easier to do what you promised yourself you would do, namely, buy low.

This behavioural crutch may not sound like much, but consider that most investors struggle with being countercyclical. They can’t bring themselves to buy when stocks are on sale.

If you’re wavering, perhaps buying strong companies will make you a little stronger in more ways than one.

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