Our objective is to maximize the future earning power of our portfolio. We mainly look to buy, at reasonable prices, excellent businesses where we have high conviction that their future profits will be significantly higher than today. Our most preferred investments are businesses which can not only sustain high returns on capital, but can also reinvest the cash generated at high returns, either internally or via acquisitions. Very few companies can meet these criteria. Our second group comprises of excellent businesses where not much capital is required to grow the business and the cash is returned to shareholders.
We focus our research efforts on selected industries and companies where we can build high conviction. We don’t invest in industries where product cycles are short, regulation or government intervention risk is high, or patents are important to the value of the business.
We prefer businesses that can grow revenues via market share gains or industry consolidation. These businesses usually offer considerably better value to their customers compared to peers or substitutes. For example, companies with significant cost advantage can sell their products at materially lower prices and maintain high returns on capital, or in industries where relative economies of scale enables the large incumbent to take share from smaller peers. The ability to gain share on a sustained basis provides us with high conviction regarding the long term profit growth of these businesses. These businesses can often grow profits even during adverse economic conditions.
We also like businesses with very strong competitive position in their respective markets where we can identify secular drivers which will drive market growth for years to come. These companies typically have large market shares and benefit from economies of scale. It will be very difficult to displace them.
Our focus is predominantly on the strength of the business rather than the rate of revenue growth. A strong business with high returns on capital and a shareholders friendly capital allocation policy can be a wonderful investment, even with a limited revenue growth.
The companies we own typically benefit from high barriers to entry and significant competitive advantages. These attributes, among others, enable us to have high conviction that the returns on capital are sustainable for many years to come.
We follow a very strict investment process. Each candidate to our portfolio is examined based on numerous criteria, both qualitative and quantitative. We conduct our own research and build our own financial models. We talk to the companies we look to invest in, their competitors, customers and suppliers. We continuously research our portfolio companies to challenge our investment theses.
We prefer to invest in companies with a long history. Past financial performance teaches us a great deal. It enables us to better understand the strengths and weaknesses of a business and the capital allocation skills of the management team. We look for organizations with healthy cultures, strong corporate governance, and where management’s incentives are aligned with those of the shareholders. Over the years, we have developed a wide network of professional colleagues with whom we frequently interact to generate and challenge our investment ideas.
Patience and Discipline
We buy a position only in businesses which meet our strict criteria (conviction), and where the current price is considerably lower than our expected fair value a few years into the future (risk/reward). The degree of conviction and the attractiveness of the risk/reward determine the position size.
The pressure to take action and deliver short term performance is the evil of investment success. Sometimes, the best thing to do is nothing at all. Our structure and incentives are tailored to allow us the required patience. This means that we can wait for reasonable prices to buy the business we want to buy. Moreover, it allows us to be patient with our investments. Certain things just take time and sometimes there are bumps along the way. Our investment horizon is measured in years, typically three to five years.
We don’t benchmark ourselves against an index. Unlike many participants in our industry, we are under no pressure to chase a rising stock market, or own stocks which are included in a particular benchmark. It allows us to focus on what really matters – enhancing purchasing power over time while protecting our capital.
We manage a concentrated portfolio of carefully selected companies. Our top 10 positions typically account for a significant portion of net asset value. No position can be more than 10% of our net asset value. We know that we don’t know the future, therefore we want to make sure that no single position can cause a significant damage to our portfolio.
Our portfolio consists of two assets: long investments in equities and cash. The cash level is an outcome of our investment process. The more high conviction investment ideas we find the lower our cash level will be. We deploy our cash only if attractive investment opportunities, which meet strict investment criteria, present themselves. This is, in our view, the only way to make significant risk adjusted returns in the stock market. Cash is also the best and cheapest hedging instrument. History has proved, time and again, that sophisticated hedging tools tend to work most of the time. Cash is money good all the time.
We sell a position in any of the following situations: 1) our investment thesis proves to be not as strong as we initially thought or, 2) the price is higher than our estimated future fair value for the business.