By Will Simpson – Portfolio Manager
The difference in our thinking is that we would rather look long and hard for an undervalued or fairly valued extraordinary company than to simply find an undervalued ordinary company.
It is true that it is better to find a fairly priced exceptional company than an exceptionally priced fair company. We find these opportunities by filtering through every stock on global exchanges. We do this through manual business model analysis combined with rigorous financial statement and notes to financial statement analysis. We preference small cap companies that exhibit rapidly scalable business models. We only invest in businesses that have an exceptional financial record, and where we believe our analysis capability can be confidently applied.
In applying our investing philosophy:
Deep dive into how we’re different
The longer we hold a stock, the greater chance we give our original analysis to be proven correct.
We’re not traders. We perform detailed analysis on the current status of the business model, the industry, the financials, and we hold for the long term. Much of the value of our analysis is in our assessment of the underlying value drivers of a business model and the robustness of those drivers. When assessing business models, our main focus is identifying those that are founded in structural change. This change represents fundamental movements in consumer behaviour or technological shifts that are creating enormous value at pace. These are not short-term trends but macro structural shifts in the evolution of consumer behaviour or the technologies that ultimately bring products or services to that consumer for their benefit.
As such, these are fast-growing businesses. The resulting share prices, however, at times lag as market participants may overlook these businesses in the short term, either due to neglect, prejudice, or simply a lack of understanding fundamental tailwinds behind the growth. These are often reasons why the investment case arose in the first place. Over the long term, however, stock prices revert to intrinsic value. It is this reversion coupled with our long-term focus and the high-growth aspects of the company’s distributable earnings that yields our results.
In this method we look for a company that has exceptional growth characteristics and exceptional financials at a price that gives us a margin of safety.
“Diversification is protection against ignorance” – Warren Buffett
Our ultra-concentrated portfolio yields results that are the most accurate reflection of our analytical capability.
When it comes to diversification we think differently. Our portfolio is ultra-concentrated holding only 8 to 15 companies at any one time. Why should we invest in our 30th best idea if we have conviction in our first 8? Our portfolio performs as it does in a large part due to substantial allocations to a few of the best opportunities in the world. Best-meaning companies with the highest growth prospects in terms of shareholder value creation, and in which we have the highest level of certainty in those future prospects. In this way, when a company does well, it makes a substantial contribution to our portfolio performance. If we were to invest in 30 or more stocks, one of those stocks could be an exceptional performer, however, it would make very little difference to our overall return due to its insignificant allocation.
Conventional wisdom maintains that a portfolio must have at least 30 stocks to be adequately diversified. Many go further to incorporate elaborate mathematics to ensure that those 30-plus stocks are uncorrelated. The reason of course is to minimise risk and volatility. The underlying logic goes that if a single investment should fail, it will have little effect on the portfolio. We argue that if stock selection is done well enough and held for long enough, the outperformance of the majority of stocks makes up for any laggers. This has been our experience. Modern diversification theory merely acts as a means of replicating the entire market. If its users find it necessary they would be better served by an index. The risk of an investment is directly related to the drivers of the underlying business model and the capability of its management. It is not the volatility of its stock price or its perceived correlation to other assets as they happen to be assembled in any given portfolio.
Learn more about our approach to risk management here.
We have developed our own unique method of analysis over 15 years of study, development, experience, and iteration. These systems and processes uncover opportunities from the ground up. That is, they sift through an investment world of over 100,000 opportunities to uncover the best-performing business models for us to turn our analytical attention to. Apart from our ESG requirements, screening is sector agnostic.
Analysing a single investment from search to purchase takes us many weeks. We use our six stage approach:
In an investment pool of over 100,000 opportunities, we filter out a shortlist using a combination of our internally developed software and manual processes. We believe our approach is quite different from industry norms. At a high level, this stage involves attention to:
“The value of analysis diminishes as the element of chance increases” – Benjamin Graham
In deciphering business models we ask ourselves five important questions:
Our analysis has limitations – there’s much we don’t know. To that end we avoid the following businesses for the following reasons:
Commodity-derived revenues – For example, we do not have the analytical ability to predict future prices of oil, wheat, or copper. Predictions surrounding international supply and demand, rainfall, and geopolitical tensions lie outside of our capacity and so we have little insight to the value of commodities.
Contract winner – This company must continually tender for, and win, contracts to carry out and increase its business. Typically in the construction industry, the company comes unstuck in two ways: inability to accurately cost new projects, and the willingness of new competitors to under quote. Examples generally include:
We don’t believe we have the analytical ability to predict future chances of this contract winner to:
Manufacturer – This company is engaged in manufacturing products for various brands. It takes raw materials and brings them together to produce given outputs. The classic example is the textile manufacturer who produces clothing for different retail brands. Ones we avoid are low in the value chain.
Logistics provider – This is a capital-intensive operation that uses physical warehouses and transport vehicles to move goods around. Examples include third-party logistics providers and traditional transit solutions over land and water. We also include airlines in this category.
We avoid the logistics provider because:
Real estate developer – This entity raises funds to develop land, usually into apartments. They purchase land, engage a construction company to build residential or commercial assets and then sell those assets. Here the developer is subject to movements in interest rates, broader economic performance, and market sentiment subject to change over the project lifecycle.
We avoid real estate developers because of:
Researcher – This company is generally in the business of biological innovation. They will create, manufacture, and innovate drugs or other health promoting agents. They compete on having the most effective treatments and so constantly research and innovate to stay ahead of the competition or to develop treatments of untreated ailments. These are often pharmaceutical companies.
We do not invest in researcher-based business models because we do not have the analytical ability to:
This analysis covers multiple data points across the income statement, balance sheet, equity statement, and cash flow statement. It also draws on insight gained from specific interrelations between these data points. At a high level we believe that:
We then turn our attention to detailed analysis of the notes to the financial statements with attention to reserve accounts, off balance sheet commitments, revenue recognition policy, and other matters as they present in relevance to the individual company in question. Checks and balances of all relevant concerns are covered more thoroughly in stage six below.
“All intelligent investing is value investing – acquiring more than you are paying for: You must value the business in order to value the stock” – Charles Munger
The market will often make prices that have no basis in a company’s current or possible future earnings. This regularly presents as greatly overestimating earnings ability, creating a price too expensive to participate in that earnings growth, or simply overlooking a sound company with good prospects leaving its share price undervalued. Therefore we must make our own independent valuation of a company’s worth or intrinsic value. In calculating intrinsic value we consider, amongst many other factors and as a broad summary, the following quantitative and qualitative elements:
We identify relevant competitor business models and perform detailed analysis on strategy and financials. We then consider how each strategy is likely to compete with that of the company in question, the performance of their financials, and the stability of their capitalisation. We analyse and record their progress over time alongside our investment.
For evolution to occur change must be beneficial to the organism. For it to be sustainable over the long term, it must coexist with, and be beneficial to, its surrounding organisms and the ecosystem at large. Evolution in business models is no different. That’s why we believe in ESG factors and have become signatories to the United Nations Principles for Responsible Investment. We integrate ESG factors into the centre of our analysis. We have a thorough, detailed ESG analysis process that has been adapted and expanded from the PRI guidelines. Please see an outline of our ESG analysis here.
“Those who can’t make the numbers might simply make up the numbers” – Warren Buffett
In this section we cover a series of checks and balances that uncovers signs of accounting manipulation.
This process accounts for some 143 data points, 46 calculations, and interrelations between those data points and calculations. Information is found within management discussion, financial statements, and notes to those financial statements. Past annual reports must also be analysed to gain insight into how these metrics are changing and to highlight any abnormalities that may be indicative of suspicious behaviour by management or other concerns. This is quite a detailed process but very broadly it involves analysis of: