Buy Quality, Buy It Now

Right now, you have the opportunity to buy many of the world's most wonderful businesses at valuations not seen in more than a decade. Why are these great businesses on sale for the first time in a long while? That's a good question, and there's a good story behind it.

One of the more common mental biases that affects people is "recency," which is the tendency to consider the most recent information as more important when making a decision instead of weighing all information equally. This cognitive trap can be especially harmful to investors, because it causes people to extrapolate the most recent trends into the future without considering the likelihood that the trend will reverse. You see this in many aspects of the financial markets--economic predictions and earnings estimates tend to become more positive after a few robust years, and they tend to become more negative after the market or economy has turned south.

One of the recent trends that many investors appear to be extrapolating into the far future is a marked lack of volatility in financial markets. All has been quiet on the western front for a few years, and as a result, the return that's being demanded for risky assets relative to less-risky assets has become very, very small. In other words, investors in just about every part of the financial markets are demanding very little return "bang" for their risk "buck." In even fewer words, they're complacent.

You can see this wherever you look. In equity markets, one good measure is the Chicago Board Options Exchange Volatility Index--the VIX--which is essentially the amount of volatility that options traders are expecting in the near future. When it's high, there's a lot of fear in the market, and when it's low, option traders expect smooth sailing in the days ahead. As you can see in the chart below, the VIX has recently been hitting its lowest levels since the mid-1990s.

While we're talking about equity markets, let's look at another indicator of the current insatiable thirst for risk: The performance of different groups of stocks over the past few years. Small caps, cyclical stocks, and emerging markets have all done extremely well relative to their larger and lower-risk peers, with small caps and emerging markets topping the category return tables for equity funds, while emerging-market and high-yield bonds have topped the fixed-income charts.

Looking at our own coverage universe, we see the same thing--the riskier the stock, the better the return. Over the past three years, the low-quality stocks in our coverage universe (those with no economic moats) have posted annualized returns nearly double those of the high-quality stocks (those with wide economic moats.) This story repeats when I slice our coverage universe by risk, with high-risk stocks performing the best, followed by average-risk stocks, and low-risk stocks bringing up the rear by a substantial margin.

Not Just Stocks
Unfortunately, equity investors are not alone. The spread, or additional yield, on low-quality corporate ("junk") bonds relative to Treasuries is at its lowest level in many years. Same goes for spreads on emerging-market bonds, which are at their lowest levels since 1998. As bond guru Bill Gross pointed out in a recent commentary, "When one can buy a U.S. agency guaranteed FNMA mortgage at a higher yield than almost all emerging-market debt, there exists an irrational pricing of credit."

Investors in these risky types of bonds are currently not getting paid very much in additional return for the risk they're incurring, which means that either a) they're so hungry for yield that they'll buy the bonds despite irrational pricing, or b) they think the future will look as rosy as the present. The first answer smacks of investors who fear being "left behind" by their peers, while the latter points to recency bias, which gets investors into trouble time and time again.

In fact, one could argue that the current extremely low yields on just about all types of long-term debt reflect a market that's not terribly worried about the risk of inflation eating away those returns down the road. There are other factors at work in keeping yields low, of course, but it's an interesting thought.

Go for Quality
So, where does this market full of risk-seeking, highly complacent investors leave us? For one, it should remind prudent investors with long time horizons that calm seas are not inevitable in financial markets. As ex-maestro Alan Greenspan put it in congressional testimony in July, "History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress."

Backing up this point, I'd note that the last time emerging-market bonds spreads were this low was mid-1998, just before Russia defaulted on its debt and Long-Term Capital management blew up. The point here is that things have a way of going wrong when (and how) you least expect. How many people in early 1998 would have listed "a hedge fund run by two Nobel Prize winners" as the biggest upcoming threat to financial markets?

More importantly, however, all this risk-seeking behavior has presented a wonderful opportunity for long-term investors to buy truly great companies at their most attractive prices in more than a decade. About one-third of our wide moat universe is currently trading 10% or more below our fair value estimate, with companies like  Wrigley ,  Johnson & Johnson (JNJ),  Avon , and  Dell  trading at their lowest prices since the mid-1990s. ( Click here to see this list.) We are also putting our money where our mouth is, with the Tortoise Portfolio in our StockInvestor newsletter fully invested with essentially no cash for the first time in its history. 

Granted, many of these undervalued wide-moat companies are more mature than they were a decade ago, and it would be rash to expect the kind of earnings-multiple expansion that supercharged their equity returns in the late 1990s. Nonetheless, you're paying very fair prices for very much above-average companies, which is a formula that has worked rather well over time. In fact, about 20 of our wide-moat stocks currently trade not just below our fair value estimate and their long-run average valuations, but also below the long-term average market price/earnings ratio of 16. ( Click here to see this list.) That seems like quite a good deal to me.

And of course, I'd argue strongly that it's precisely this group of companies--ones with wide moats and reasonable valuations--that will hold up best should we hit a speed bump in the financial markets. At least, they'll certainly hold up better than the risky junk that's been topping the performance charts.

Conclusion
Am I worried about something in particular? Nope. But when risk premiums are very low, and complacency is the order of the day, it seems prudent to think about what could go wrong. Combine that with wonderful companies at attractive prices, and I think the prudent course of action is clear: Buy quality, and buy it now.