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Huerta de Soto: Never Invest in a Company Until You Know Its Worth

July 9, 2018 in Featured, Interviews, The Manual of Ideas

We recently had the pleasure of interviewing Juan Huerta de Soto Huarte, investment analyst at Cobas Asset Management, based in Madrid, Spain. Juan has worked with Francisco García Paramés for over five years, both at Bestinver and Cobas. Juan has also worked as an analyst at azValor Asset Management.

The following interview has been translated from Spanish.

MOI Global: Tell us about your educational background and your experience.

Juan Huerta de Soto: When I finished high school, I did not have a clear vocation, so I decided to follow the advice of my family and study Law and Business Administration and Management at the Complutense University of Madrid. It is a long degree program (6 years), but it gave me a little more time to discover what I wanted to do, and it helped me avoid specializing in any particular sector too soon. This turned out to be a very good decision, because initially, I had wanted to study law, and had I done that, I might not have discovered value investing. In my first years at the university, I was more interested in laws and their practical application. However, in my third year, I took an Introduction to Corporate Finance course and since then, my interest has focused on the world of business, finance, and economics.

I owe my discovery of value investing to my family as well. As you can imagine, much of what I am today is due to them. More specifically, my older brother recommended I read One Up on Wall Street, by Peter Lynch, to get me started in the world of investment. Though I was pursuing a degree in business, it was not until I read Lynch’s book that I began to grasp what it meant to invest wisely, and from that point on, my intellectual interest has focused almost entirely on investment and economics. It is curious to note that my brother found that book thanks to the readings recommended by Bestinver Asset Management, a prominent independent asset-management firm in Spain and, at that time, the employer of Francisco García Paramés and his team, with whom I would come to work years later.

When I finished Lynch’s book, I began reading every book I could find about value investing, watching every interview and lecture that featured the Bestinver team (practically the only value management firm in Spain at the time, and by far the largest and most successful), and investing my small savings in Bestinver funds and in Spanish listed companies. My first investments in listed companies awakened my passion for business analysis and ultimately revealed to me a desire to devote myself professionally to financial analysis and investment.

Even so, desires are not everything, and at that time, it was difficult to find work at a value management firm in Spain, mainly due to the shortage of companies with that particular investment philosophy. Therefore, I decided to work toward a master’s degree in applied economics with a focus on the Austrian School of Economics at the Universidad Rey Juan Carlos. Fortune smiled on me, and a junior analyst position opened up at Bestinver just as I was finishing my master’s degree and my internship was drawing to a close. In September 2013, I joined the team of Francisco García Paramés. Almost two years later, the investment team decided to found an independent asset management firm, thus ending a relationship of many years with Bestinver. Fortunately, they decided to count me in on the project, and as soon as I left Bestinver, I joined the rest of the team at azValor Asset Management. These were good years, in which I acquired practical knowledge not found in books, and I was able to develop as an analyst, sharpen the skills I had, and learn new ones. In the end, after nearly two more years, Francisco García Paramés, who had not joined azValor due to contractual impediments, decided to found his own investment firm. I was invited to take part in the project, and I accepted. It has been a year and a half since then, and I hope to keep contributing to this exciting project for the rest of my professional life.

MOI: What are the investment criteria of Cobas Asset Management? How has it evolved over time?

Huerta de Soto: At Cobas we are not dogmatic, but the opposite. We think flexibly, and that enables us to invest whenever a series of basic preconditions are met. When I say that we are not dogmatic, I mean that we do not limit ourselves to a particular investment style, which quite frequently happens nowadays. In other words, we are not one hundred percent deep value, nor do we belong exclusively to the school of Buffett and Munger (quality companies at reasonable prices). Instead, we invest where we think value exists and the market is inefficient. For instance, right now the US stock market is high, as is part of the European market. They are close to their highest levels in the last twenty years, so we have no problem looking for opportunities in other parts of the world, such as in Asia, where a substantial portion of our portfolio is currently invested.

Another good example would be cyclical sectors, especially raw materials. In the past, we have preferred to invest in companies with a clear competitive advantage, a high return on capital, and a certain pricing power; that is, the exact opposite of commodity sectors. However, due to the expansion of credit orchestrated by central banks since the financial crisis of 2008 and to decreases in interest rates to historic lows, holders of the newly created money have sought a decent return, first in fixed income investments, thus causing an unprecedented bubble, and then in certain equity sectors, such as quality and dividend-paying companies.

Consequently, in our opinion, at the present time, good companies, as I have defined them, are quite expensive in general, while certain sectors, such as the maritime transport of raw materials, and oil and gas, among others, are close to their lowest levels in the last ten years. If one knows how to search well and is willing to carry out a comprehensive analysis of such sectors, it is possible to find good companies, with good management teams, little debt, and great potential for appreciation.

With these two examples, I have attempted to illustrate the flexibility that characterizes our investment process. We feel that a good investor must be capable of generating value in any economic context, and not only when the stock market drops and the best companies become affordable. It is necessary to go where a strong discrepancy exists between value and price, and that is what we at Cobas try to do at all times.

As for the basic preconditions we want fulfilled, the most important are the capacity to understand the company (the famous “circle of competence”), clean accounts and a healthy balance sheet, the quality of the management team, and above all, the price. When it comes to the price, one might say we actually are a little dogmatic, since, as a general rule, we are not willing to pay a high price because the company is a particularly good one or because considerable growth is expected. We tend to think that the main risk we face is that of overpaying, which usually occurs when one is overly generous with the initial price and the margin of safety with respect to valuation is not wide enough. Beyond that, if, within the specified criteria, we find a company with barriers to entry and high returns on capital, we always tend to prefer it over another company in the same circumstances but without competitive advantages.

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July 6, 2018 in Twitter

The Roles of Skill and Chance

July 5, 2018 in Commentary, Featured, Letters, Skills

This article by MOI Global instructor Daniel Gladis is excerpted from a letter of Vltava Fund, a global equity investment fund launched by Daniel Gladis in 2004.

I have had a book of the famous Feynman Lectures on Physics on my nightstand for a long time. It is wonderful reading, although I must admit many things in the lectures are too difficult for me. One of the lighter lectures is entitled Probability, and in it Feynman tells about how people see patterns or designs even in entirely random phenomena.

Here is Feynman’s example. Take a coin, which has a 50:50 probability that its tossing will result in heads or tails. Toss it 30× and record the number of heads. Repeat this entire experiment 100× and then consider the results. If there is a 50% probability in each toss that the coin will come up heads, we would expect that in each such 30-toss experiment the number of heads will approach 15. However, only 12 experiments resulted in exactly 15× heads. In 88 cases, the numbers of heads were different and ranged between 9 and 23.

If we continue tossing the coin on and on, however, the number of heads will in fact gradually approach one-half of all tosses, even though the probability that a head appears exactly 15× in 30 tosses is less than 15%.

The individual sequences of 30 tosses were also very interesting. Feynman shares the three following sequences:

TTHTHTHTTTTTTTTTHHHTTHTTHHTHTH – 11× heads, 19× tails, with tails 9× in a row

HTTTTHTTTTHTHTHHHTTTTHTTHTHTTH – 11× heads, 19× tails, with tails 8× in the first ten tosses

THTTHHHTHHTTHTTHHHTTHHTHTHHTHT – 16× heads, 14× tails, with neither side appearing more than three times in a row

These sequences may seem a little unusual, but if we know that the coin is fair, such that the probability of a toss resulting in heads is truly 50%, then we can admit that these results are within the confines of our expectations and that they may not be the result of any pattern or design. They are just common fluctuations entirely normal for this particular game.

Now let us consider, for example, that the first sequence represents returns achieved by a portfolio manager instead of coin tosses. Let us replace heads and tails with pluses and minuses, respectively. A plus represents a good period, and a minus represents a bad period. A good period may be one in which the portfolio manager’s gain is positive in absolute terms or better than that of a comparable index, and a bad period may be one where the portfolio manager is in loss in absolute terms or performed more poorly than did a comparable index. That choice is up to the evaluator to decide.

This specific sequence of the portfolio manager’s returns would thus look like the following:

− − + − + − + − − − − − − − − − + + + − − + − − + + − + − +

Nine bad periods in a row! Such a portfolio manager would probably be out of work for a long time, because his or her clients would have concluded that the manager’s investment abilities are miserable. Ha! In a coin toss, which is an activity where skill plays no role, tails appear 9× in a row and we consider it common fluctuation, whereas we regard an investor’s nine bad periods to be automatic proof of incompetence. What if the role of chance is bigger than we think it is even here? Is there any way to know? We cannot successfully measure it precisely, although we may estimate it at least a little. Particularly important is to consider the length of the monitored periods. If they are nine weeks or nine months, then the role of chance will be so great as to render the results meaningless. I believe the same applies for nine quarters. But nine years? In that case, yes, an investor’s skill will very probably dominate over random effects.

What exactly happened to David Einhorn?

An article with this title was published during May in Institutional Investor, and it inspired me to choose the topic of this letter to shareholders.

David Einhorn is one of my favourite investors. In 1996, he founded his company Greenlight Capital, and over the following 17 years he achieved an average return of 19.4% per year (source: Frederick Vanhaverbecke: Excess Returns, Harriman House, 2014.) This is an excellent result that ranks him among the best investors of the latest generation.

His results have been somewhat worse over the past four years. Judging by the returns of Greenlight Re, the returns of a portfolio managed by Einhorn were as follows:

2015: −20.2%
2016: +7.2%
2017: +1.5%
2018: −12.5% (January to April)

This is nothing horrific, but it is enough for some people to forget 17 years of excellent returns, for some investors to leave Greenlight, and for some authors, who usually cannot show any official investment history at all (not to mention any comparable to Einhorn’s), to write articles referring to Einhorn as an investor who has lost his investment abilities (sometimes even using very indiscriminate language). But how representative are these most recent three years really? I think not very. As an example, let us look into history.

Graham’s children

In 1984, at the occasion of the 50th anniversary of the publication of Security Analysis (by Graham and Dodd), Warren Buffett gave a legendary lecture at Columbia University, the content of which he later transcribed into the article The Superinvestors of Graham-and-Doddsville. Among other things, in the article he describes the returns of a group of investors who had close relationships with Benjamin Graham and whose investments followed in the footsteps of his value investing. They were the following investors or funds: Walter Schloss, Templeton Growth Fund, Warren Buffett, Sequoia Fund, Charles Munger, Windsor Fund, Pacific Partners, and Tweedy Browne.

What this group of investors had in common was not only a spiritual father (Graham) and value investing, but also greatly above-average returns. All significantly beat the US equity market. For the entire period of their activities evaluated, which ranged from 13 to 31 years among the individual managers, their average annual returns were between 13.9% and 32.9%, and their returns exceeded those of the index by 3.4 to 25.1 percentage points per year. What is extremely interesting is that every one of them – without exception – spent a considerable amount of time lagging behind the index. Buffett lagged behind in just 1 year out of 13, but the others’ results were poorer than those of the index in approximately one-third of the years. Let me repeat that: a group of legendary investors who substantially beat the indices, the returns of whom almost everyone would be more than pleased to claim as their own, had substantially below-average results one-third of the time. This sort of thing is the rule rather than the exception.

What do these findings mean?

1. It is possible to achieve substantially above-average returns over the long term, and investor skills are a decisive factor.

2. It is not possible to expect that above-average returns will be achieved in every short evaluation period. There, the role of chance is too large.

3. A value-based investment strategy does not bring above-average returns at all times and under all circumstances – and that is precisely the reason why it works over the long term.

4. Even the best investors spend a part of their careers on the lower rungs of the ladder.

All these points apply also to Vltava Fund. Over 9.5 years – that is the entire time the Fund has been applying its current investment philosophy – our returns have been 210 % higher than the returns of the comparable

MSCI World Equity index (our total return for this period is 346 % or 17 % p. a.). Moreover, the Fund has done so with a portfolio that has much lower risk than that of the index. If someone were to have asked me 9.5 years ago if this result would have been acceptable to me, I would not have hesitated for a second. Even despite this strong outperformance, there were several longer periods in this time when we were lagging behind the index. Chance certainly contributed to the overall result. Sometimes this was to our advantage, sometimes to our disadvantage, but its total influence is gradually diminishing with time.

Back to David Einhorn

Considering the above, I would certainly not be among those who would write off Einhorn. His results in recent years in no way slip beyond what can be expected. Moreover, I do not believe investment abilities can be lost. One can lose the ability to run, for example, but it does not work that way in investing. To the contrary, investors should get better and better with increasing experience and absorbed knowledge.

If we choose 20 people at random from a group of swimmers and let them swim for 400 meters, we can rank them according to their performance. If we let them swim the same distance of 400 metres the next day, their ranking will probably be completely the same. There, skill plays a decisive role. But when we select 20 investors and rank them by last year’s returns, their ranking at the end of this year will probably be very different. Neither of these annual results will be very informative as to those managers’ real investment abilities. We would need a much longer period to determine those.

In no case do I want to state that investing is a matter of chance. It certainly is not. Investing is a matter of probabilities, and those can be strongly skewed to the investor’s advantage due to his or her abilities. What I am trying to explain is that every phenomenon contains a certain element of chance and that the human brain has a tendency to underestimate its influence. Our brains try to find order and cause even when these are not present, and that is a mistake. Chance plays its role also in investing, and it can produce seemingly unanticipated results in the short term. One should count on that. Nevertheless, the influence of chance is gradually reduced with the increasing length of the time series, and investor skill eventually comes to dominate. This period is certainly longer than several quarters.

This is my reasoning behind my view on David Einhorn. A couple years of relatively poorer results tell us nothing about his investment abilities. The future will probably prove that these are still excellent, and his investors should instead consider adding to their investments in Greenlight Capital. Of course, all this is based on the assumption that David Einhorn does not let the superficial judgements of those around him get him down, and that he will continue in his business. Many successful portfolio managers have quit because they got tired of endlessly explaining their investment strategies and defending their methods, returned the money to their investors, and continue to manage just their own portfolios at peace and without stress.

I would not be surprised if Einhorn ran out of patience, and perhaps he should. It must be very frustrating for him to watch those around him judge him based solely upon short-term momentary returns and completely glossing over the fact that, for example, the net leverage of Greenlight Capital’s portfolio (again according to statistics from Greenlight Re) has been only around 33% over the long term. Therefore, his strategy comes with greatly below-average market risk. Everyone is interested in returns but scarcely anyone asks about the risk a fund undertakes, even though these two things are inseparable from one another.

I am describing the case of David Einhorn in this letter because he is a well-known and much-followed investor. However, this entire situation can be generalised and used as a textbook case of how investors should orient themselves among funds. Decisions about whether they entrust someone with their money or not should not be based on whether a particular fund has had good or bad results over the past couple of years. It should instead be based on whether the investors understand the portfolio manager’s investment philosophy and can identify with it. If they do not know it or have a problem with it, then they should not invest in the fund no matter how good the results have been. On the other hand, if they put in the work, understand the portfolio manager’s investment philosophy, and like what they see, then this argument must through the long term prevail over any transient below-average performance of the fund that cannot be entirely avoided. This approach, however, requires a willingness to undertake certain effort necessary to understand the investment philosophy and it demands patience. Unfortunately, both of these are in rather scarce supply in the world of investing.

Frequency of statements

Investing is an activity that involves a great deal of subjectivity. It is highly dependent upon the questions one asks and the perspective and detachment with which one views things. A long-term manner of thinking is one of the key conditions for rational investing. This is something everyone should realize, even those who are now summarily condemning Einhorn. In this respect, I must admit my pride in feeling that Vltava Fund’s investors share with me this opinion and long-term view. One of the bases for this feeling of mine is the fact that there are increasing numbers of questions from our shareholders as to whether it would not be sufficient to send out the Fund’s performance results on a quarterly instead of monthly basis.

Our shareholders are apparently aware of the fact that movements of equities prices are altogether random in the very short term but very well predictable over the long term. This is, after all, the key to successful equity investing. In such an environment, it is desirable to completely ignore short-term results and focus solely on long-term goals. This is not easy, and so sometimes we must remind ourselves to do so.

We decided to accommodate these requests, and, starting from this month, you can request to change the frequency of statements to quarterly. The Fund’s NAV will continue to be calculated once a month. Nothing will change about that. If you want to continue receiving your statements every month, you need not do anything. If you want to receive them on a quarterly basis, let us know (and of course you can switch back at any time). There is convincing evidence that the less an investor follows the development of his or her investments (within certain limits, of course), the better investment decisions he or she makes. Receiving statements at a longer frequency will reduce noise and increase the information value of those statements one does receive. Having said that, it is still my opinion (and consistent with the view expressed in this entire letter to shareholders) that even one quarter is too short a time for drawing any conclusions.

Changes in the portfolio

There was no reason to make substantial interventions into the portfolio composition during the past quarter. The companies in our portfolio have been showing very good profits, which is something you can easily verify by yourself. This year they have been performing perhaps the best ever in several recent years. If you get the impression that this is not much reflected in their share prices, I agree with you. Such periods are relatively common. This is not the first time we have been in such situation, and certainly it will not be the last. Sooner or later, however, the share prices will follow the development of their underlying value, just as they have in all previous cases. That is one of the few things one can rely upon in investing.

On behalf of the entire Vltava Fund team, I would like to thank you for your participation in the recent Shareholders Meeting. Attendance was record-breaking, and the almost family-like atmosphere surpassed that of all 13 previous annual meetings. We very much appreciate the opportunity to work together with a group of such pleasant and similarly thinking shareholders. It is a great honour for us. We thank you and wish you a lovely summer.

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Disclaimer: Our estimates and projections concerning the future can and probably will be incorrect. You should not rely upon them solely but use also your own best judgment in making your investment decisions. This document expresses the opinion of the author as at the time it was written and is intended exclusively for educational purposes. The information contained in this letter to shareholders may include statements that, to the extent they are not recitations of historical fact, constitute “forward-looking statements” within the meaning of applicable foreign securities legislation. Forward-looking statements may include financial and other projections, as well as statements regarding our future plans, objectives or financial performance, or the estimates underlying any of the foregoing. Any such forward-looking statements are based on assumptions and analyses made by the fund in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors we believe are appropriate in the given circumstances. However, whether actual results and developments will conform to our expectations and predictions is subject to a number of risks, assumptions and uncertainties. In evaluating forward-looking statements, readers should specifically consider the various factors which could cause actual events or results to differ materially from those contained in such forward-looking statements. Unless otherwise required by applicable securities laws, we do not intend, nor do we undertake any obligation, to update or revise any forward-looking statements to reflect subsequent information, events, results or circumstances or otherwise. This letter to shareholders does not constitute or form part of, and should not be construed as, any offer for sale or subscription of, or any invitation to offer to buy or subscribe for, the securities of the fund. Before subscribing, prospective investors are urged to seek independent professional advice as regards both Maltese and any foreign legislation applicable to the acquisition, holding and repurchase of shares in the fund as well as payments to the shareholders. The shares of the fund have not been and will not be registered under the United States Securities Act of 1933, as amended (the “1933 Act”) or under any state securities law. The fund is not a registered investment company under the United States Investment Company Act of 1940 (the “1940 Act”). The shares in the fund shall not be offered to investors in the Czech Republic on the basis of a public offer (veřejná nabídka) as defined in Section 34 (1) of Act No. 256/2004 Coll., on Capital Market Undertakings. The Fund is registered in the Czech National Bank´s list in the category Foreign AIFs authorised to offer only to qualified investors (without EuSF and EuVECA) managed by AIFM. Historical performance over any particular period will not necessarily be indicative of the results that may be expected in future periods. Returns for the individual investments are not audited, are stated in approximate amounts, and may include dividends and options.

What Is An Investment Process?

July 3, 2018 in Commentary, Equities, Featured, Idea Appraisal, Idea Generation, Letters, Portfolio Management

This article is authored by MOI Global instructor Mark Walker, a global equity investor and managing partner at Tollymore Investment Partners, based in London.

An investment process is a set of guidelines that govern the behaviour of investors in a way which allows them to remain faithful to the tenets of their investment philosophy, that is the key principles which they hope to facilitate outperformance. An investment process should allow the manager to stay the course in periods of underperformance or other source of self-doubt. It is the process which gives investment managers a better chance of making good decisions consistently though a market cycle. The investment process is a set of inputs that are designed to drive an output – satisfactory investment returns.

Some friends of mine at large asset managers claim that my investment operating system is not a process. The main sources of contention seem to be that a real investment process is easily described, and that it is repeatable. Institutional capital allocators also seem to broadly require that an investment process have this quality of repeatability for a strategy to be investable.

Repeatability is indeed a desirable characteristic, but often repeatable is inappropriately conflated with quantitively led processes, characterised by the use of statistical screens highlighting cheap, out of favour stocks. Users of quant screens, sometimes in the form of proprietary idea generation engines, argue that simply by fishing in a certain pond, they are tipping the odds of achieving a satisfactory investment result in their favour.

There are several issues with this:

  • While selecting investment opportunities from a screen may have helped the manager to outperform in the past, there is no guarantee it will in the future, especially considering significant business model changes from the industries of history vs. those of the future.
  • Repeatability implies copyability. Predicating a source of investment edge on something that can be replicated tips the odds against you in achieving a satisfactory investment result. The capacity for contrarian thinking is limited by the preponderance of investors using screens as their primary or only idea generation filter.
  • Screens miss one of the most compelling sources of mispriced securities: those companies whose reported financials poorly reflect the underlying cash earnings’ power of the business, due to for example high reinvestment rates, inappropriate accounting policies or business model transitions.

While less convinced about the value of stock screens than many in the asset management industry, I do use some basic screens to potentially highlight names that are “cheap and good”, but screens have driven a minority of investment ideas. Most investment ideas are driven by energetic engagement with company filings and transcripts, industry reports, fund manager letters and the authors of these letters in one on one and conference settings, and value investor publications. It is a multi-touchpoint approach that fosters both independent thinking and intelligent, intellectually generous and appropriately aligned collaboration.

Idea generation is an ‘always on’ activity, occasionally accelerated by buyside investment conferences. Recognising an opportunity when one sees it is a more valuable skill than looking for opportunities in an information-rich world. A very concentrated investment portfolio and a global opportunity set afford me the luxury of saying “No” to a significant majority of opportunities at a very early stage. For those ideas which look interesting, brief documentation of their potential investment merits helps to determine how time should be spent on more substantial due diligence efforts.

The research process is bottom-up, one company at a time. Blocks of uninterrupted focus are dedicated to gathering data, facts, logic or other evidence which help me to form an opinion about the company’s economic characteristics and private business value. These characteristics include business simplicity, capital structure, track record, competitive positioning, reinvestment opportunities, stewardship and valuation.

There are no predetermined ways that I am seeking to form a positive conclusion on the company’s business characteristics. I am looking for competitively strong businesses which ideally have avenues for profitable redeployment of capital for a long time, whose uses and sources of finance are appropriate for the business model, and whose management is properly incentivised to make the best capital allocation decisions that will create the most long-term value for owners. Each potential investment candidate is assessed at face value and using available facts. This is one step removed from saying that I am looking for capital light platform businesses with recurring revenues and high insider ownership, for example. The capital light, recurring revenue nature of the business may well be desirable, but there are other ways to create high quality business models and sustain competitive strength. Likewise, high insider ownership may or may not satisfy the requirement that managers are aligned with owners. Each business is assessed on its merits, from a blank sheet of paper.

The result is a portfolio that is concentrated with regards to the number of holdings but is diverse in terms of geographic and industry end markets, business models and organisational and ownership structures. All portfolio companies have strong competitive positions and enjoy high barriers to entry that should sustain supernormal profits on existing assets for a long time. They differ in the extent to which they can redeploy capital into growing the normal earnings’ power of the business, and the cost of that intrinsic value growth. Holdings can be grouped into three broad categories: capital light compounders, reinvestment moats, and legacy moats. Broadly speaking, the multiple of owner earnings I am willing to pay for a capital light compounder is higher than that for a reinvestment moat, which is higher than that for a legacy moat.

I have never found the concept of investing according to ‘style factors’ intuitive. Fund managers seem to explicitly or implicitly categorise themselves as ‘value’, ‘growth’, or ‘GARP’. By doing so they are placing themselves at various points on the PEG curve below. Investors are willing to pay higher multiples for businesses which can grow their earnings faster. The massive shortcoming in this framework is the lack of consideration for the cost of the company’s growth. If company A and company B both grow earnings at 10% pa, we should not be willing to pay the same multiple if company A can achieve that growth with modest capital reinvested, while company B needs to reinvest substantial portions of prior earnings. An investment approach focused on returns on capital allows an investment manager to consider the cost of earnings’ growth in estimating private business value.

There is a growing chorus of deep value investors lamenting the underperformance of their investment ‘style’ and calling a bubble in moats and compounder investing. Whether or not such a bubble exists, this bottom up, first principles process helps to safeguard against being on the wrong side of that bubble bursting. I have visited many quality-focused investment conferences over the last few years; most of the investor discussion seems to be oriented around deep value and capital cycle investment themes and ideas. The bottom line is that there just aren’t that many high-quality businesses, let alone attractively priced ones available on the public market. The discovery of mispriced great companies is a perennially tough challenge, and I am trying to find 10-15 in a universe of tens of thousands. For a diversified manager this challenge is immeasurably more difficult.

Estimating private business value typically involves using cumulative qualitative research to estimate the normal earnings’ power and achievable reinvestment rate of the business, and the incremental cash returns that could be earned on redeployed capital. The output of this is a range of IRRs that could be enjoyed at current prices. Ideally a conservative appraisal would lead to an IRR in the high teens. The goal of the portfolio management strategy is then to augment this return to equity owners by occasionally and sensibly responding to stock market volatility by averaging down or up in response to material market moves inconsistent with changes in fundamental business prospects. This is one of the major advantages of public vs. private equity investing. Public equity volatility can lower risk of permanent capital loss by allowing us to lower our average purchase price and avoids the temptation of employing leverage to juice returns. This approach to public market investing means that volatility is welcomed, and no efforts are made to smooth investment returns. Risks of permanent capital impairment are mitigated by avoiding leverage at the portfolio and company levels, employing a long only strategy, and averting intrinsic value erosion by investing in high quality businesses.

Valuation may be a reason to sell an entire position, but unless extreme overvaluation occurs, it is more likely to drive portfolio rebalancing decisions. Reasons to dispose of entire positions are more typically the result of fundamental shifts that undermine my perception of the company’s competitive position, or subsequent evidence which refutes my prevailing view of a business’s or management’s quality.

So, the key aspects of an investment process govern idea generation, investment research and portfolio management. Overarching these three pillars is a belief that execution is everything. A sensible long term, business owner investment philosophy is of no use if the investing ecosystem is a barrier to faithfully executing a thoughtful investment process. A great investing ecosystem must cultivate a bi-literate brain; one capable of navigating data and filtering noise; and one capable of deep work in a digital era. It seems to me the obvious source of investment edge is behavioural. Constructing a low-key physical working environment free from distraction and conducive to independent thinking, and having an investment philosophy and investor base matched to an investment manager’s temperament are crucial determinants of a long-term successful outcome.

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