Methodology – the Enactment of Philosophy
We would rather take our time to find an undervalued or fairly valued extraordinary company than to easily 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:
- We must be able to confidently understand the business model, the drivers behind it, and its competitive landscape.
- We preference rapidly scalable businesses with positive distributable earnings from an early stage.
- We have global coverage but with investments mostly held in Australia and The United States.
- We strive for low portfolio turnover. Ideally we would hold a stock forever however dynamics of market forces don’t allow us to.
- We have high portfolio concentration. Opportunities that match our criteria are few.
- We keep our team small for two reasons. Firstly, we believe that when it comes to investing diversity of thought leads to market replication. Secondly, as the manager of the portfolio I need to have an in depth and current knowledge of each of our investments and opportunities. For the portfolio to be optimised no knowledge can be left siloed in any one individual.
- We draw modest salaries. We accumulate our personal wealth through long-term holdings in our investments, not through management fees. Each of us have all of our wealth outside of our residence invested in the fund.
- We keep office expenses modest. We share facilities with others in a coworking space allowing us to minimise expense, meet new friends. And there’s the free coffee.
- We promote a culture of humility. Ego inhibits success, humility enables learning and understanding.
Deep dive into how we’re different
Low turnover, long-term investing
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.
An ultra-concentrated portfolio
Too much diversification means outperformance is mathematically impossible, it’s a miniature replication of the index.
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.
A different approach to screening
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:
- Stage One. Initial filter of a global database of over 100,000 opportunities.
- Stage Two. Detailed analysis of the business model drivers.
- Stage Three. Detailed financial statement and notes analysis.
- Stage Four. Calculation of intrinsic value and competitor analysis.
- Stage Five. Detailed ESG analysis and consideration.
- Stage Six. Accounting manipulation checks and balances.
Stage One: Rapid filter of a large universe
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:
- Economies and governance issues revenues are derived in.
- Return on invested capital and growth rates of distributable income.
- High-level business model analysis with identification of how value is created, and suitability to our ESG screening. This is a manual task that can take a number of weeks in itself.
- Income statement, balance sheet, and cash flow statements. Analysis of these statements and interactions between them.
Stage Two: Detailed analysis of the business model drivers
The application of analysis is only relevant when the drivers of price and volume are clearly understood.
In deciphering business models we ask ourselves five important questions:
- How does this business add value?
- What mechanism/s does this business use to create revenue?
- Is this business one we can confidently apply our fundamental analysis and growth projection to?
- Is the business model good for people and good for the environment?
- Are there any obvious ESG issues that would prohibit us from investment?
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:
- Commercial and residential construction.
- Infrastructure builder of government initiatives – e.g roads, bridges, tunnels, ports.
- General government procurement such as marketing, engineering, logistics, defence equipment, building construction and consulting.
We don’t believe we have the analytical ability to predict future chances of this contract winner to:
- Continue to win larger values of contracts.
- Continue to quote these contracts accurately and maintain margins.
- Avoid material liquidated damages.
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.
- Power cables
- Wafer silicon
- Copper wire
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:
- Logistics solutions are a commodity with vast numbers of competitors mainly competing on price.
- Material changes to profit subject to the price of oil, a commodity we can’t predict the future price of.
- High labour costs consistently increasing.
- Large investment in depleting assets in constant need of replacement.
- High depreciation expense.
- High lease expense.
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:
- Inherent requirements for large debt loads.
- Inability to scale at speed.
- Reliance on domestic economy with frequent inability to grow internationally.
- Reliance on very specific local economies and positions.
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:
- Confidently understand the revenue streams well enough to be able to identify the competition.
- Understand the intricacies of the treatment in how easily it might be replicated or superseded.
- Be aware of current research and progress of current trials that may compete with or supersede the treatment under our analysis.
Stage Three: Detailed Financial Statement and Notes Analysis
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:
- Companies must have robust growth in revenue. The product or service should be good enough to propel its own popularity in the market without the need for exuberant marketing spend.
- Balance sheets must have sustainable levels of debt and adequate cash reserves.
- The cash flow statement must fit with all other analysis in uncovering distributable earnings or at least a clear pathway to positive and growing distributable earnings. Distributable earnings being cash-flow generated from business operations available to equity holders as opposed to accounting profit or net income as displayed on the income statement.
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.
Stage Four: Calculation of Intrinsic Value and Competitor Analysis
Market capitalisation matches value by chance, not design.
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:
- Strength of financials.
- Reproduction cost.
- Distributable earnings as opposed to accounting earnings.
- Value of the company as it is now.
- Value of growth.
- Present value of future cash flows.
- Risks to future cash flows.
- Identification of underlying business model drivers and the robustness of these drivers.
- Relative position of the individual company in the industry.
- The company’s physical, geographical, and operational characteristics.
- The capability and character of management.
- The outlook for the company, the industry and business in general.
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.
Stage Five: Detailed ESG Analysis and Consideration
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.
Stage Six: Accounting Manipulation Checks and Balances
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:
- Earning quality calculations in the reported financial statements.
- Statements from management, their highlighted performance metrics, and how these change over time.
- Governance structure and governance risks.
- Revenue recognition policy.
- Off balance sheet commitments.
- All reserve accounts – the need for their existence, balances, and changes over time.
NEXT: Blue Oceans approach to sustainability.