🥇10 Lessons from 20 years of quality investing

By Morgan Stanley

Jan 18

Only a few companies are able to consistently compound shareholder wealth at superior rates of return over a very long period of time.

In our article My Quality Investment Philosophy you could already read how we think about quality. But what about other quality investors?

In this article you’ll find 10 lessons learned from 20 years of quality investing by Morgan Stanley.

The definition of a ‘Compounder’ by Morgan Stanley

For Morgan Stanley, it all starts with the moat or competitive advantage of a company. Moats make it difficult for competitors to re-create or duplicate a successful company’s business model.

A moat alone is not enough. Compounders enjoy a sustainable, high return on invested capital (ROIC), which is generated by a combination of recurring revenues, high gross margins and low capital intensity.

This combination helps to support strong free cash flow generation.

Now you know how Morgan Stanley defines a Compounder, let’s get to the 10 lessons learned from 20 years of Quality Investing.

1. Pick great stocks and let them compound

When you invest in Compounders, you focus on companies with the following characteristics:

High returns on operating capital employed
Low volatility of margins
Pricing power
Limited leverage.

You want to invest in companies with these characteristics. When they are able to grow their sales and free cash flow per share at an attractive rate, you’ve found a potential compounding machine.

2. Know what you own

Only focus on the highest quality companies in the world.

When you don’t understand the business model of a company, you can skip the company right away and put it in the ‘too hard’ pile.

3. Trust your instincts on management

You want to invest in companies where management shares your long term perspective:

Their desire to invest in long term intangibles such as advertising and promotion
Their ability to innovate and allocating capital efficiently

Managers tend to do what they are paid to do.

Are they paid to think about return on capital, or just grow earnings?

Take a look at how they are paid and if you don’t like it, stay away from it.

4. Benchmarks are risky

Benchmarks themselves are inherently risky.

If you hug the benchmark, you’ll deliver benchmark-like returns (at best).

“It is impossible to produce superior performance unless you do something different from the majority.” – John Templeton

As an active investor you’ll by definition underperform the market from time to time.

There are many strategies which have proven to be successful in the long term:

Quality investing
Low volatility investing
Companies with skin in the game
…

Pick a strategy that suits you and stick to it.

5. Risk management is important

Many academics measure risk by volatility.

However, the best definition of risk is the following “Risk is the chance you’ll permanently lose money.”

When you want to invest successfully, focus on risk management first and returns second.

"Rule No.1: Never lose money. Rule No. 2: Never forget rule No.1." - Warren Buffett

6. What you don’t own is just as important as what you do own

As a quality investor, you don’t want to invest in cyclical stocks like commodities or low margin stocks.

Focus on quality stocks in quality sectors. Sectors like healthcare, software, and consumer staples. These sectors have proven to offer attractive returns as well as downside protection.

7. Express your conviction

Reflect your conviction in your portfolio.

It doesn’t make sense to focus on your thirtieth best idea.

Instead, focus on your best ideas and put the most money in those stocks.

"Diversification is protection against ignorance. It makes little sense if you know what you are doing." - Warren Buffett

8. Valuation matters

Even great companies aren’t great investments if you pay too much.

Valuation matters. The free cash flow yield is a great way to look at the valuation of a stock.

Most things you want to own come your way eventually, even it is way too expensive right now. Be patient.

9. Maintain a long-term perspective

Trying to beat the market every year is futile.

What matters is winning over years and decades.

The best investors focus on the long term.

10. Remain curious

Samuel Johnson once said: “When a man is tired of London, he is tired of life.”

You can say the same about the stock market.

The secret to success in the stock market is to remain curious and continue to ask the right questions.

“I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.” - Charlie Munger

All rules in one picture

Here you can find all Morgan Stanley’s rules in 1 picture:

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About the author

Compounding Quality is a professional investor which manages a worldwide equity fund with more than $150 million in Assets Under Management. We have read over 500 investment books and spend more than 50 hours per week researching stocks.

Compounding Quality