Value investing has evolved from the simple low price/book and price/earnings ratios as espoused by Benjamin Graham. But despite being almost a century old, we believe many of Mr Graham’s core principles remain valid – such as the usefulness of historic fundamental company data for objective analysis, and the premise of not “paying up” for future growth. We believe that when buying shares, you are buying a small piece of the business. So for this reason we focus on business value.
Our view is that behavioural biases (such as overconfidence, endowment effect, and loss aversion) often lead to prices differing significantly from value. By recognising this, and developing processes to ensure that we do not succumb to these biases, we believe we can take advantage of the investment opportunities that result. We are not afraid to be contrarian.
We believe the structure and incentives in the traditional investment industry are generally detrimental to investors. Examples include: the business and career risks associated with truly active portfolio management; the lack of fundamental research of small companies; the focus on both short-term and relative performance; and the prevalence of conflicting interests. We are happy not to be burdened by these constraints and conflicts that institutional asset managers continually face.
The one key component of our “edge” is “time arbitrage”, ie the preparedness to ride out volatility and hold for the long term. We are willing to be patient and accept the vagaries of the market as we believe this will lead to superior longer term investment performance.
Traditional finance theory and most market participants view risk as volatility. However, we view volatility as a source of return, rather than a component of risk. Our view is that risk is subjective and cannot be accurately measured (not even in hindsight). Investment results vary based on a plethora of outcomes. No one knows how an investment portfolio would have behaved in different environments. No one can accurately predict which outcome will eventuate.
We have a cynical view of much of “Wall Street’s” activity. We are sceptical of one’s ability to forecast macro variables, predict industry trends and identify future leaders. We believe that “noise” such as daily commentary, business channels, and real time prices are distractions to sound investment management.
By accessing the broadest array of investment opportunities we can build a higher quality portfolio at a cheaper price. The types of businesses we seek are usually more attractively priced in global markets, and often amongst the smaller capitalised entities. Many are not represented in the indices, have too little liquidity for the larger asset managers, and consequently are under-researched. We are comfortable in taking positions in these businesses when they are available at attractive prices.
We like to keep within our “circle of competence”. We do not wish to employ esoteric methods such as “shorting”, as we believe it would increase the Fund’s risk profile. We do not like the maths associated with unlimited downside and capped upside. We also will not try to enhance returns by leverage at the fund level. And we seek and embrace the diversified currency exposure that investing in global businesses offers.
We have no regard to indices. Whilst we acknowledge the benefits of diversification, we do not feel this is achieved simply by holding many positions. On the contrary, by holding a large number of positions we would dilute the impact of our “top picks” and our investment performance would suffer. We believe that holding an appropriate portfolio of around 25 positions is optimal.
We have rules in place that require diversity of holdings across industries, countries and currencies. We believe that a concentrated portfolio of well diversified businesses will generate the best investment outcomes. Our portfolio reflects a balance between the prudence of holding businesses with operations across different sectors and regions, along with our confidence level in the businesses, the declining marginal benefits of diversification, and the prices we must pay to access those businesses.
Complementing our focus on absolute returns, we believe that a substantial part of the asset allocation function is best determined by the portfolio manager. A reasonably unconstrained portfolio of quality global businesses, which holds cash in the absence of opportunities at the right price, makes utmost sense.
We are selective in the businesses we invest in – they typically have readily understandable and transparent business models, have exhibited strong past returns on their capital, and have a solid track record of earnings and cash flow. We analyse businesses with regard to the total capital (including debt) employed in their operations, This means we do not invest in companies that rely on financial leverage to offer attractive returns (such as banks, and many utilities, infrastructure and real estate vehicles).