Philosophy – thought processes discovering principles

Don’t expect unusual outcomes by acting in a usual fashion

Question everything and decide for yourself what is true. Mainstream investment methodology is considered unchallengeable, we disagree. We have studied the common wisdom and chosen our own path through extensive research and years of investment experience. Our philosophy has yielded different logical conclusions and those conclusions form principles that guide our methodology. A sample of our philosophical thinking is given below.

Mainstream Wisdom Blue Oceans Thinking
Value opportunities can be found by looking at low PE ratios. PE ratios are made up of two erroneous metrics leading to an erroneous conclusion. P, the stock price, likely won’t reflect the true value of the company and E, earnings, comes from net income, a calculation for tax purposes and not actual cash flows from the business. We do not consider PE values.
WACC is a critical component of valuation. Risk is directly related to the drivers of price and volume and not the expected return of investors. Why should their collective expectations necessarily be correct? Why would a small cap growing at 30% p.a. with multiple macro tailwinds represent more risk than a large cap growing at 5% p.a. in an industry undergoing widespread disruption? We do not use WACC in valuations.
Beta is a true measure of risk. Again, it is the drivers of price and volume that constitute an investors risk. It is not recent movements in stock price relative to its index or its peer companies. We do not use beta in valuations.
The CAPM is essential in calculating the discount rate. Our focus is entirely on the individual business performance and not the market its stock price is quoted on. We do not recognise significance in expected stock market return, beta, or the market risk premium. If an investor is concerned about short term market movements they are speculating and not investing. We do not use the CAPM in our valuations.
The terminal value formula is correct and an essential part of DCF valuation Calculating WACC including beta on a company today produces a wide margin of error. The calculation estimated many years in the future is nonsense.
A portfolio must have at least 30 stocks to be adequately diversified. Mainstream diversification theory makes exceptional portfolio performance mathematically improbable. Assembling a large portfolio uncorrelated stocks merely creates a replica of the index. We are content in holding 7 – 10 of the best opportunities available and do not follow mainstream diversification theory.
A rational investor only holds a portfolio on the efficient frontier. Levels of variance of expected returns and estimated standard deviations do not combine to provide insight. Our focus remains on the factors concerning the individual business situation. We do not use efficient frontier theory in managing our portfolio or in making purchase decisions.
The best talent can be found from the best business schools. Mainstream wisdom is taught at all leading business schools and so hiring individuals who have excelled at learning and applying that school of thought would diminish our value not increase it.
Be aware of and make provision for black swan events. Unexpected events can occur at anytime causing dramatic market movements and that does not concern us. We stay focused on the performance of businesses in our portfolio and searching for new opportunities. Macro events rarely impact the trading conditions of businesses we own and the effects on their share prices are temporary.
If a stock price rises and that company becomes a large part of your portfolio you need to sell a portion of it to rebalance the portfolio so all stocks have much the same weightings thereby reducing risk. Rebalancing relates to mainstream thoughts on maintaining diversification. Our tolerances are for a much more concentrated portfolio and we allow stocks to grow larger portions of the overall portfolio than mainstream would allow. The risk is in the business model, if that business model is performing exceptionally well we continue to hold our position.
Pick an industry that is likely to outperform and buy the best stocks in that industry. When looking for new investments we scan every company on global listed exchanges. In that way we know which companies have the best performing business models and we are not attempting to choose an individual industry or sector.
Buy into cyclical stocks at the bottom and sell them at the top (buy low, sell high). Frequent trading produces a large tax burden. Timing entry and exit points cannot be done accurately over long time-scales. Commodity industries are prone to complex factors making estimations of future cash flows void. Commodity industries usually do not align with sustainability. We do not invest into cyclical business models.
If a company misses guidance, sell it. Guidance in our view is unnecessary and prone to error. We would rather see managers managing a company to current conditions, not investor expectations.
If a company misses analysts expectations, sell it. The opinions of analysts are irrelevant.
Small caps hold greater risk than large caps and should be valued accordingly lower. In our experience the reverse is more often true. We analyse the risk of small caps and large caps in the same way. We do not believe small caps hold more risk than large caps simply because they are smaller.
A capital raising increases valuation. A company’s value is its ability to generate cash flows and not its popularity amongst investors.
Companies can be grouped into sectors and good diversification is spread amongst multiple sectors reducing risk. Apart from our sustainability criteria we are sector agnostic. Diversity amongst business models in the same sector is immense. The concept of sectors is irrelevant to us.

Buy the right company at the right price and leave it be.

When it comes to investing, we look to Bertrand Russel’s In Praise of Idleness, “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” We believe one must have utter conviction in the strength of analysis and then leave it be. In the absence of material deviation from your analysis, leave your investments to mature as the laws of nature and physics demand. The progression of strategy and market has nothing to do with revolutions of the sun or the end of the financial year. It need not be linear either. 

Difference in value calculation mechanics

In considering valuation, one should be aware that this is a subjective pursuit and that the mechanics of deriving valuation should be simple. We do not agree with mainstream investment methodologies that weigh heavily on estimations and assessments of risk unrelated to underlying business drivers.

However, as Einstein said, “Everything should be made as simple as possible, but no simpler.” There’s much more to valuing a company than a PE ratio. The financials, as displayed in annual reports, are in accordance with accounting requirements and conventions. They are a starting point for analysis, not conclusions in themselves. We rewrite the accounting for any business that we’re looking at. We use our standard approach to rebuilding financials to derive distributable earnings, which allows us to compare different business models under the one framework. The method has proven itself over many valuations in many different markets. 

Intrinsic value is a subjective approximation. An item may be worth more to one who has specific knowledge over it and who attributes a greater potential for it in the future, than is recognised by another. It is that specific knowledge that will lead to markedly different results in valuation as it relates to those inputs in the calculation that require estimation. We believe modern investment theory becomes far removed from the underlying business situation with measures of risk not related to underlying business drivers and with too many inputs derived from estimations. Its users have succumbed to precision bias. In models involving multiple estimates over long time scales, the resulting calculation, whilst complex and laborious to derive, provides little insight. It simply leads the analyst to feel they have a correct answer having gone to such trouble in deriving it. In evaluating a useful model it must have as few inputs of estimation as possible. Those estimates necessary must be conservative to be as certain as possible. One must also be careful as to which business models they choose to make estimates on. When it comes to buying equity in businesses, one needs to pay a price that allows for error in valuation. One needs to find business models that have high degrees of probability in their outcomes as determined by the insight of the purchaser. 

Perspectives on risk

Mainstream convention holds that risk is volatility and beta is a measure of that volatility. For us beta has no place in our assessment of risk. We have a long-term horizon, and short-term movements in the stock price are irrelevant to us. Movements of entire markets are not reflective of an individual company’s situation. Even the short-term movements of an individual stock price can vary wildly from the underlying business case. Why then should the short-term movements of a stock’s market price bear weighting on the valuation of the underlying company? It’s the dynamics of the underlying revenue drivers over a multi-year time horizon that represent our risk. We look at a business model and consider what it might look like in 10 years and what level of probability we can attribute to that future. It doesn’t matter to us if a small company has short-term volatility along its multiyear CAGR of 40%, as opposed to the perceived “less risky” company producing 5% growth per year. Conventional wisdom says the small cap is far riskier than the large cap. This thinking does not reconcile with us. Furthermore, from our point of view there can easily be more risk in the stable large cap then the fast-growing small cap. Aged business models are all undergoing some form of disruption. Consider banking. Convention wisdom will tell you that a young fintech growing revenue at 35% per annum with profitable cash flow from operations and taking market share is riskier than holding an established bank that is undergoing disruption and losing market share. Variance punishes downside and upside. For us, this makes no sense. We focus our thoughts on the fundamentals of the business model and the probability of acceptable returns over the long term. If the probability of acceptable returns looks high vs the probability of losing money, we make an investment. Beta is not linked to the underlying business fundamentals and has no use in our analysis. 

Portfolio concentration demands exceptional analysis and that takes time

“It is trying to carry too many baskets that breaks most eggs in this country. He who carries three baskets must put one on his head, which is apt to tumble and trip him up. One fault of the American businessman is lack of concentration.”Andrew Carnegie, 1885

Quality analysis leads to high degrees of certainty. In theory, if you were certain a stock was going to rise 80% in the next 12 months and would continue to do so for the next 10 years, you would sell all of your worldly possessions and just own that stock, nothing else. However, the only thing certain is that we certainly can not know everything about anything. So we need some diversification, however, don’t let diversification increase your risk by insufficient analysis due to lack of time and bandwidth. Einstein said “It’s not that I’m so smart, it’s just that I stay with problems for longer.” I wager that you cannot adequately analyse and monitor 30 companies and their competitors. Further, I wager that if you were to rank those 30 companies in order of quality, the bottom 5 would not be justified in being in the portfolio when compared with the top 5 and they are in fact adding risk not subtracting it. Those that believe they need diversification to cover risk, as is the conventional wisdom, are better served by indexes. For investment success one must be truly passionate about doing it. Once the initial analysis is done, and the investment is made, it takes assiduity to maintain performance. All things are in constant flux, an irrational obsession builds a safe harbour. 

Black swans, white swans, and very boring swans

We can’t predict markets movements. We continually search for great businesses, with able management, selling at attractive prices. When we find an opportunity that matches our criteria we buy it. We pay no attention to macroeconomics or market forecasts and we don’t attempt to make our own. Markets can suddenly collapse, rocket upwards, or go nowhere for long periods of time without warning. When it comes to macroeconomics and the complexity of the interconnectedness of the world and all the actors in it, we don’t believe it is possible to make predictions. The media regularly identifies key individuals that predicted the last recession or market collapse. We must keep in mind that someone, somewhere, is always making predictions and creating logical arguments around them. The only certainty is that at some point a random event will align with someones logical reasoning for it.   

The arithmetic of tax consequences favor the long-term investor

  • Starting Value $100,000.00
  • CAGR 15%
  • Tax on Sale 39% (income $90k to $180k inc. Medicare Levy)
  • Short-term Investor sells holding at the end of each year.
  • Long-term Investor sells holding twice over 10 years.
  • Australian Taxation Law.
Short-term Investor Long-term Investor
Year Accumulated Wealth Annual Gain Before Tax Tax Event On Sale Realised Value Year Accumulated Wealth Annual Gain Before Tax Year End Value Total Taxable Gain Tax Event On Sale Accumulation Year End / Realised Value
0 $100,000.00 $15,000.00 $5,850.00 $9150.00 0 $100,000.00 $15,000.00 $0 $15,000.00
1 $109,150.00 $16,372.50 $6,385.28 $9150.00 1 $115,000.00 $17,250.00 $0 $17,250.00
2 $119,137.23 $17,870.58 $6,969.53 $9150.00 2 $132,250.00 $19,837.50 $0 $19,837.50
3 $130,038.28 $19,505.74 $7,607.24 $9150.00 3 $152,087.50 $22,813.13 $0 $22,813.13
4 $141,936.78 $21,290.52 $8,303.30 $9150.00 4 $174,900.63 $26,235.09 $0 $26,235.09
5 $154,924.00 $23,238.60 $9,063.05 $9150.00 5 $201,135.72 $30,170.36 $231,306.08 $131,306.08 $31,487.90 -$1,317.55
6 $169,099.55 $25,364.93 $9,892.32 $9150.00 6 $199,818.17 $29,972.73 $0 $29,972.73
7 $184,572.15 $27,685.82 $10,797.47 $9150.00 6 $229,790.90 $34,468.63 $0 $34,468.63
8 $201,460.51 $30,219.08 $11,785.44 $9150.00 8 $264,259.53 $39,638.93 $0 $39,638.93
9 $219,894.14 $32,984.12 $12,863.81 $9150.00 9 $303,898.46 $45,584.77 $0 $45,584.77
10 $240,014.46 $36,002.17 $14,040.85 $9150.00 10 $349,483.23 $52,422.48 $401,905.72 $202,087.54 $49,629.46 $2,793.03
Ending Value Yr 10 $261,975.78 Ending Value Yr 10 $352,276.26

The long-term investor is better off by 34.7%.

Selection process of new hires, a radical approach

We don’t look to the most prestigious universities or big names on resumes. In fact we don’t pay much attention to resumes at all. Our way of thinking about investing is different and so we teach new recruits our methodologies ourselves rather than outsource that education to a university or leverage off their prior experience. With this being the case, we don’t need to hire employees with finance backgrounds. In fact to avoid ingrained biases, it makes little sense to do so. We gain more from their unique knowledge in other areas. We have codified the mechanics of our financial analysis.. We look for energetic, super smart, creative people with specific knowledge different to our own, and a hunger to learn. With that, we follow the onboarding process below. 

1. Selection for intelligence from a large sample size.
We leverage genetic variation in populations lacking opportunity. Minimum sample size is 1,000. These people are graded on intelligence by taking an online exam as the first filter. The exam includes over 40 questions including mathematics, reading and comprehension, and critical reasoning. The questions are derived from the Medical Entry Exam and are very good at assessing a person’s natural intelligence with the least amount of influence from previous education. There is also a short essay component designed to allow the applicant to express areas of their specific knowledge and ability to communicate. Data from previous hires has shown minimum scores required to perform well in the role. 

2. Alignment.  
After selecting candidates meeting minimum thresholds from the above sample size, we then filter for alignment. We take cues from the applicants essay, CV, cover letter. Applicants meeting those requirements are then directed to take the Myers & Briggs MBTI personality assessment. We use those results to confirm alignment to our requirement and preference desirable personality types we don’t currently have in the team. 

3. Communication skills and an analytical mind.
It’s critical the applicant is a good communicator. We conduct a skype interview and assess the quality of dialog through conversation around the applicants specific and general knowledge. We also conduct a case study to  evaluate the applicant’s ability to make well-formed assumptions in calculating the breakeven point of a small business with limited available data. They must make a series of sensible assumptions and be able to justify their reasoning. 

4. Performs in our environment. 
The nature of our work environment requires team members to be able to perform independently and often alone. They must possess the talent and drive to ask questions and form answers themselves. To self-direct, learn, and discover. We have developed a number of tools and manuals that guide to our procedures and reasoning but to deliver real benefit a team member must be able to develop their own viable investment thesis utilising the application of their own knowledge, research, and conclusions. 

Inspired by these great thinkers

You must decide for yourself what is true. Learn from others to develop knowledge, use that knowledge with your creativity to find your own truth.

Bertrand Russell
Bertrand Russell: In Praise of Idleness, 1932.
Charles Munger
Charles Munger: Seeking Wisdom by Peter Bevlin, 2003. Poor Charlie’s Almanac, 3rd Edition, 2005.
Barbara Minto: The Pyramid Principle, 1987.
Andrew Carnegie
Andrew Carnegie: The Gospel of Wealth, 1889.
Warren Buffet
Warren Buffett: Letters to investors and shareholders, 1958 - Present.
Robert McLean: Bulletproof Problem Solving, 2018.
Blaise Pascal
Blaise Pascal: Pensees, 1670.
Benjamin Graham
Benjamin Graham: Security Analysis, 1934. The Intelligent Investor, 1949.
John Burr Williams
John Burr Williams: The Theory of Investment Value, 1938.
Bruce Greenwald
Bruce Greenwald: Value Investing, 2001.
Ray Dalio
Ray Dalio: Principles, 2017.