Our investment process consists of three main parts:
- Creating and Cultivating the Universe
- Building the Portfolio
- Monitoring & Reassessment
The first step involves creating a “Universe” of roughly 40 businesses that, at the right price, we would like to own in our portfolio. These are businesses that are leaders in their field, have strong management, and are likely to generate EPS growth of 12-15% per annum for the next 5-7 years. We identify potential candidates through industry networks, trade journals, consultants and our own experience. Once a potential candidate is identified, we conduct a preliminary but extensive qualitative assessment of the company. Specifically, we research the industry to understand the environment it faces; we study and evaluate the company’s strategy for growing earnings; and we look closely at any potential cyclicality or vulnerability to exogenous factors the company may have. We prefer to invest in companies that have minimal exposure to the broader economic cycle and enjoy some sort of competitive moat within their industry.
This qualitative assessment then informs our analysis of the company’s financial statements. We look for consistency as well as proof that management has been executing their stated growth strategy. We closely study cash flow, debt levels and other factors that speak to a company’s sound financial footing. Once we have a command of the company’s financials, we begin a dialogue with company management to deepen and refine our understanding of progress towards their goals.
The portfolio is built by selecting from the businesses that have made it into the Universe, with valuation being the main driver for inclusion. Based on our financial analysis, qualitative assessments and management meetings, we build a detailed financial model that projects each company’s financials over the coming five years. Based on our projections, we come up with a 5 year forward estimated stock price, which is then discounted back to the present at a rate that varies depending on the perceived challenges in that company’s business model and a healthy risk premium. Our appraisal of fair present value is compared to the current stock price, and the difference is the appreciation potential. Typically, shares in the 15-20 businesses with the greatest appreciation potential are included in the portfolio at any given time, with their weight influenced by appreciation potential, industry concentration, and relative volatility.
All of the companies we follow, whether in the portfolio or in the Universe, are continuously monitored and reassessed. We try to meet with the companies, their customers and their competitors on an ongoing basis, and attend industry events to stay current. While we aim for relatively low turnover, we recalibrate our models and adjust positions when appropriate, rotating out of overvalued shares into those with greater appreciation potential. Businesses that remain solid, well-run companies with strong growth prospects remain in the Universe even after being removed from the portfolio. These businesses will often, at some point, become attractive again from a valuation perspective, and re-enter the portfolio. Our continuing involvement and ongoing appraisal of these companies and their managements permits us to be prepared to move adroitly when opportunities present themselves. Only when there is a negative change in a company’s fundamentals such as management, competitive environment, growth prospects, etc. would that business be removed from the Universe.
We are continuously looking for new potential candidates for the Universe. Between monitoring those already in the Universe, and constantly evaluating new candidates, ours is a research-intensive process. It is the depth and intensity of that research that helps us build great conviction in the businesses we invest in and, historically, conviction leads performance.