We believe that choosing investments using a value investing approach produces extraordinary results over the long term.
Our philosophy is that constructing a concentrated portfolio of high-quality stocks priced at low multiples of earnings and cash flow with good balance sheets and durable competitive advantages will outperform the general market. By “high-quality” we mean that we look for companies that are consistently able to reinvest a majority of their earnings back into the company and earn high rates on their invested capital. These companies are the compounders, that can build their intrinsic value consistently over time and create extraordinary returns for investors.
We believe a bottom-up investing approach produces superior results. Part of the reason is that it’s simpler. Bottom-up investing starts at the company level, analyzing a stock’s fundamentals and determining if it’s a good investment on its own, irrespective of what’s going in the larger economy or world.
While investors should be aware of factors in the global economy, investing with a top-down approach is simply too hard. There are too many interrelating variables in the world that make it impossible to consistently predict which investments are superior with a top-down approach.
Quality at a bargain price drives our investing philosophy. There are high quality companies and there are companies that are cheaply priced.
It’s rare to find high quality companies at a cheap price. Usually high-quality stocks are expensive for a reason and cheap stocks are cheap for a reason.
Charlie Munger, partner of Warren Buffet once said, “When you locate a bargain you must ask, why me God? Why am I the only one who could find this bargain?”
There’s reason to be skeptical when you find a good deal. Quality at a bargain is difficult to find. You’re competing with millions of investors. Are you really that much smarter?
At times however, markets behave irrationally and give us an opportunity to take advantage of mispricings.
When we invest in a stock, we’re taking a partial ownership position. We have to ask before investing, “What are we receiving for the price paid?’ Warren Buffet famously said, “Price is what you pay. Value is what you get.” We have to be aware of what we’re receiving and why we expect the price paid to intrinsic value gap to close, thereby making us a profit.
Investors in a stock can profit in one of three ways. Firstly, from free cash flow generated by the business resulting in dividends or a higher share price. Secondly, from an increase in the multiple of earnings that investors are willing to pay for the business. Thirdly, from a closing of the gap between stock price and intrinsic value. We expect to invest in stocks where the risk-reward ratio is high that one of the above occurs.
If investors are willing to put in the work and patience, they can find the holy grail of investments: Quality stocks at bargain prices.
Mohnish Pabrai, one of the best value investors of all time, said “You don’t make money when you buy stocks. And you don’t make money when you sell stocks. You make money by waiting.”
There needs to be a willingness for investors to wait on the sidelines until opportunity arises. There’s nothing wrong with holding cash even as the crowd is buying.
When you find stocks that have a history of high returns on capital with no red flags priced below their intrinsic value, you have an opportunity.
How do we determine what constitutes a quality stock that’s a good value?
We run screens to find stocks that have a history of high returns on invested capital (ROIC) over the past 8 years as well as positive free cash flow. Specifically we look for high returns on incremental capital invested, meaning we look how much a company has earned on the capital that it has reinvested in the business.
We look at companies that have been able to compound their intrinsic values over the years. Specifically, the intrinsic value compounding rate is equal to ROIC * Reinvestment Rate. ROIC is return on incremental capital invested over the years. Reinvestment rate is the amount of retained earnings increase divided by the cumulative earnings over the period. We are looking for compounding rates of at least 20%.
We then sort the stocks based on the lowest multiples of enterprise value to their earnings before interest and taxes (EV/EBIT) as well as their price-to-earnings (P/E) ratios. These are the relatively bargain-priced stocks from the ones with high intrinsic value compounding rates.
The next step is to look at various metrics for each stock to judge quality. Quality is determined by running each stock through some forensic analysis. We measure return on capital, free cash flow, profit margins, debt ratios and other measures to see which stocks have a history of consistency and high performance. This will indicate companies that have durable competitive advantages.
We then start researching each of these stocks, scouring through all financials such as annual and quarterly reports. We look to see if management is competent and if they’re looking to maximize shareholder value. We ask ourselves if these companies are likely to be around and have the same competitive advantages and be able to achieve the same ROICs as in the past. We ask ourselves if we understand the business the company is in. Is it an industry that’s rapidly changing that could erode their competitive advantage? Or do they possess some sort of “moat”, say with their technology or scale or network advantage, that can allow them to keep growing?
A final investment “buy” decision is made once we’ve identified a company that we believe can continue to achieve high returns on incremental invested capital in the coming years and is priced at a relative bargain.
- Micron Technology (MU)(20%)
- Show Denko KK (TYO:4004)(10%)
- Tokai Carbon Co (TYO:5301)(10%)
- Current holdings as of July 31, 2019