Invest In Quality Not Quantity

By Sham Gad | June 15, 2012 AAA

Strangely enough, most investors commit a very basic mistake when they make investments. They choose quantity over quality. Psychologically, people find it very appealing to own 10,000 shares of a $1 stock versus 100 shares of a $100 stock. All the while, investors fail to forget that the size of pizza hasn't changed - it's merely 100 slices or 10,000 slices. The painful reality is that by choosing quantity over quality, the lack of quality increases the risk assumed, leading investors to sell at the first sign of trouble.

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Keep It Simple
Warren Buffett, perhaps the world's most successful investor, has a unique ability to make very sophisticated investments that have created great value for his holding company Berkshire Hathaway (NYSE:BRK.A, BRK.B). Yet as Buffett will tell you, the most successful investments that created the greatest value for Berkshire were those where Buffett chose quality over quantity. Buffett made a huge investment in Coca-Cola (NYSE:KO) in the 1980s. The cost of that investment was roughly $1.3 billion. Today, that stake is worth around $14 billion. What that gain does not reflect are the dividends that Berkshire has received each year from its ownership in Coke. Berkshire owns about 9% of Coke's shares.

In 2011, Coke paid out $4.3 billion in dividends, $360 million of which went to Berkshire. Berkshire's biggest stock investments have been heavy on quality, as Buffett deeply values intangibles like brands, market leadership and durable businesses.

SEE: Think Like Warren Buffett

Boring Is Quality
At the end of the day, stock prices anchor on earnings growth. The highest quality companies are those with consistent records of profitability. Exciting industries can be profitable, but they invite lots of competition, which ultimately serves to erode profitability. Boring businesses don't invite competition and as such, can generally be counted on for generating consistent profits at an acceptable rate of growth. WD-40 (Nasdaq:WDFC) is a great example. The company makes a boring product that has been in use for decades.

However, the profits for WD-40 are anything but boring. Investors can count on around a 2.5% dividend yield each year. Same idea with The Hershey Company (NYSE:HSY). Candy doesn't change much and there is no fear of technology risk in chocolate. And people will always eat a little (maybe a lot) of candy. Therefore, it's no surprise that HSY has a return on equity (ROE) that would excite anyone: an ROE in excess of 70%. In today's zero percent interest rate environment, the 2.3% dividend is oh so sweet.

The Bottom Line
Investing benefits those who are patient and harms those who seek excitement. The passage of time allows for compounding to go to work, which is the greatest value creating force in investing. Investing in quality should be a starting point for all investors.

At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.

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