Our method towards investing has evolved over the years. We started as a pure value investor focus on identifying undervalued securities that is mispriced by the market and at the same time looking for catalyst that might rerate the securities to its intrinsic value. Sometimes it is simply the cyclical nature of the industry that leads to mispriced situation (i.e. commodities industry such as cement, crude oil, particle board, CPO, coal, airline services & etc that moves oversupply and undersupply), and in this case the catalyst usually comes from the shutdown of some players and corresponding reduction in industry capacity. Very often there is no easily identifiable catalyst in the near-term and we will wait patiently for it to come. With some luck, we have also succeeded a couple of times in creating such catalysts and we exit when the price moves to its intrinsic value. This approach to investing has served us well since many years before we started the current OPCM fund. In fact, a lot of work in identifying mispriced securities can be automated and we have built a simple quantitative model that works reasonably well in doing the job. In the near term, we estimate around one-fifth of the portfolio will continue to be deployed in such manner.
Traditional value investing is a repeating process of looking for mispriced companies, buy it, wait for it to rerate, then sell it. This process pays little attention to the durable competitive edge of a business and the quality of the people behind it. Generally, it ignores the important fact that majority of wealth in this world is created via long-term holding of companies that has a core competitive advantage, operate in a large industry and run by very capable and progressive management with high level of integrity.
The followings work like a checklist in our mind when building up the core holdings of the portfolio:
1. Integrity of the management and owner-oriented mindset
Businessman v.s. Investor
Businessman owns and manages the horse (business). They are the jockey and can steer the horse whichever way they want to. They also decide where the prize money from the race (i.e. company’s profit) would go.
We as an investor, often as a minority, neither have the way to control the jockey nor the skills to steer the horse, solely relies on the jockey to both work hard and treat us fairly. Even if one day we have controlling stake in a business, we still won’t have the skills to steer the horse, just that we would have the right to change the jockey in a worst-case scenario.
A management with integrity will pass along the economic benefit derived from the business to its owner. The added benefit of management that has integrity and transparent is that, over the years, the average valuation of the company will almost certainly be higher than its competitors throughout good and bad times. The track record of a transparent management gives confidence to shareholders as they know what is going on and what to expect. Over time reputation and trust will build up among the investment community. At times the valuation will become irrationally high, to convince the shareholders to sell the shares is like asking the diehard fans of Paul McCartney to sell you his concert’s ticket by offering a high price.
Owner-oriented mindset in terms of profit allocation
We have come across far too many honest and good management with a habit of piling up cash year after year without much justification. Very often they are not able to redeploy the cash back into the business as there isn’t much potential for further growth and eventually the return on equity gets lower and lower over time. It has the effect of turning a good investment into a mediocre one over a long period of time and this is what we want to avoid as well.
2. A sound business model that we can confidently identify its competitive advantage.
Competitive edge may appear in many forms, some are durable while others are temporary. Even one that is considered highly durable may also become irrelevant due to technological advancement. For example, the invention of automobile diminished the significance of railroad network. The mass adoption of internet technology to deliver instant news without physical constraint led to the bankruptcy of many newspapers that were once considered as impenetrable.
Major sources of competitive advantage include
- network effect (i.e. Facebook, Paypal and Microsoft);
- lowest cost operator (i.e. Hartalega, Asia File and Amazon);
- powerful branding (i.e. LVMH, Rolex and Dettol);
- ecosystem (i.e. Tencent & Apple) &
- technological advantage (i.e. ASML and TSMC).
There are many businesses which we won’t be able to understand and identify its competitive edge and in such cases we are better off sticking to what we can comprehend.
3. Operating in a sufficiently large market where it can grow for at least several years.
Or a cash cow without growth and doesn’t require capex in excess of depreciation to maintain the business.
While our preference is to go for company that has room to grow, we are equally happy to own company that has strong and predictable earning power and has minimal capex requirement. Such business should be paying out nearly all of its earnings each year and typical has very high ROE. We will treat it as a perpetual bond-like equity that give us ultra-high yield to be redeployed into other opportunities each year.
4. Run by capable managers with a progressive mindset. Eventually, we are betting on people.
In an industry, from one company to another, the most important determinant of success is the people behind it. Perhaps it is a simple concept but it took us quite a while to figure it out.
For a company to be able to grow profitably in the long term, it is a prerequisite of the management to possess a progressive mindset. Progressive management will keep thinking about how to bring the business to another level and exploring new revenue stream that may sustain the growth of company when it has maxed out the existing source. It will be spending on R&D either to improve its current processes or to develop new product, usually it will represent a meaningful percentage of its operating income.
Probability wise, many R&D projects will not succeed. However, progressive management understands that while the cost of failed R&D projects is high, the cost of doing too little R&D maybe even higher.
5. Purchase price
It may not be as difficult as it seems to identify great businesses, the real challenge lies with how to buy one at a price that would make it an intelligent purchase. If we overpay for a great business, then we would either lose money or making subpar return in the long run. If we overpay for a lousy business, we are bound to experience permanent loss of capital. In this area we utilize the value investor side of us, we do not want to overpay, even for great company led by great manager. We are willing to pay a fair price to establish a position and will be thrilled to buy aggressively if it becomes undervalued.
The above is a summary of our investment’s philosophy. Among the hundreds of companies that we look at each year, few will qualify these criteria and also available at a price that will make it an intelligent purchase. Hence, we will run a concentrated portfolio as mentioned above, and we are bound to experience big swing as the share prices of our core holdings move up or down. This is what you should expect in the future as well.