Whatever the broader economic backdrop, we believe there are always opportunities and superior companies that can take advantage of them – but they can be few and far between. The challenge for us, therefore, is to achieve a deep understanding of prospective holdings, identifying risks to business models and growth expectations, as well as the industries in which they operate, to enable us to assess whether their long-term potential is appropriately valued.
On the one hand, our approach implies there are indeed market inefficiencies that we can exploit; and our experience tells us this is certainly the case in European equities, as it is elsewhere. On the other, it implies the need for almost forensic analysis to give us the confidence that we have found a mispriced business exhibiting the sort of quality and growth potential that is worthy of a long-term investment.
Our investment approach has the following characteristics:
- We seek to identify long-term excess returns that are underappreciated by a market driven by short-termism.
- We typically favour quality franchises with high barriers to entry, and growth companies supported by secular, rather than cyclical growth drivers.
- Our business model analysis is thorough, and we utilise Porter’s Five Forces to assess industries and competitors.
- We have a long-term investment horizon; turnover is low, and we expect company growth to compound shareholder value.
- Our approach is high conviction and benchmark agnostic; we only buy companies we like and have no obligation to hold index giants.
- We keep the strategy fully invested and do not make tactical allocations to cash.
- Our understanding of valuations is informed by cash flow and returns metrics, not short-term earnings.
Long-term excess returns underappreciated by market driven by short-termism
In our experience, short-termism in the market can create opportunities for long-term investors committed to conducting thorough analysis. It is common knowledge that mean reversion is a feature of real-world economics. Thus, businesses that earn high returns on capital tend to attract competitors who then compete away those returns on capital back down towards the cost of capital. We see this feature underpinning market behaviour. We have observed that the equity of the best businesses is often mispriced and believe diligent analysis can identify ways to exploit this anomaly. But why is there a mispricing? The rise of short-termism in equity market behaviour in recent decades is wholly at odds with the investment horizon of business management teams and their broad base of stakeholders. This mismatch in time horizons creates an inefficiency that we seek to exploit.
We have seen that there are businesses that stand out, companies which deliver higher returns, higher growth rates and sustain them for much longer than the majority of professional stock market investors are prepared to ascribe value to. This is because they have protective moats around their business. Market myopia means it can take a long-time for the stock market to recognise the true value of some highquality growth assets, so patience is required.
Fig 1. Inefficiency we seek to exploit
The nature of competition
Understanding the nature of competition within an industry is vital to our long-term approach. Industries where many businesses sell a similar product often face intense competition that results in commoditisation and anaemic long-term returns on capital. At the other extreme, industries that enjoy a natural monopoly often see their profitability determined by regulators. Somewhere in the middle, we can identify industries that operate in quasi-oligopolies where profitability can be sustained.
Where we find attractive industry structures, e.g. where there is no single customer who can drive prices down and where there is no single supplier who can squeeze margins, then we start to get businesses that can generate consistent cashflows. Businesses that can generate sustainable and growing cashflows tend to have the opportunity to reinvest in their businesses for more growth in the future and deliver higher investment returns that are not simply competed away. When we find such businesses we are looking to buy and hold.
We target investments in businesses where we have identified sustainable competitive advantages and attractive industry economics. We invest in these companies and allow the economics of the business to create a compounding effect over the long term. It is this long-term compounding of capital being reinvested in a business at a high rate of return that helps drive the growth in value of a business and deliver attractive long-term growth for investors. We fundamentally believe that equity returns are best understood at the level of the individual business. The economics of businesses and of industries will determine long-term investment returns, not the macroeconomics of central banks, politicians and regulators.
Identifying secular growth opportunities
Our time-intensive process begins with identifying companies with strong business models exposed to secular growth, with sustainable returns on capital and first-class management teams. We are seeking genuine growth companies; long-term winners. Our process seeks to find the best of these from the universe of European-listed equities. Identifying such businesses often requires significantly more work and insight than many market participants can give time to, assuming they have the capability. The universe of companies that we can fish in is large and there will always be better ideas that could fit in our portfolios. We are always on the hunt for those new ideas.
Fig 2. Structural growth opportunities
Sources of sustainable competitive advantage
There are a variety of business characteristics that may yield a competitive advantage. Some companies benefit from several. Some examples are: Intangible Assets: Patents, brands, regulatory licenses and other intangible assets can prevent competitors from duplicating a company’s products or allow the company to charge a significant price premium. Network Effect: A network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. Cost Advantage: In some industries, the lowest cost producer wins. Low-cost operators can expand their businesses into new areas and squeeze competitors while increasing their profits. This is the flipside of the premium pricing seen in luxury goods markets. Lowest cost producers benefit by slowly and steadily growing their economic moats, making it ever harder for their competitors.
Fig 3. Sources of sustainable competitive advantage
Business model analysis: Porter’s Five Forces
As part of our process, we use Porter’s Five Forces – a technique for analysing industries and competitors. Porter identified five forces that play a part in shaping every market and industry in the world. The forces are frequently used to measure the competitive intensity, attractiveness, and profitability of an industry. These forces are:
Competition in the industry: When competitive rivalry is low, a company has greater power to charge higher prices and set the terms of deals to achieve higher sales and profits. Pricing power is one distinctive feature of the types of business we look to invest in. Businesses tend to have this when the service or product they offer is not easily replicated or replaced and when the product/service is mission critical or represents a small portion of spend for the customer. We want to understand if a business has pricing power or if it faces pricing pressure.
Potential power of new entrants into the industry: The less time and money it costs for a competitor to enter a company’s market, the more a company’s position may be significantly weakened. An industry with strong barriers to entry is an attractive feature for companies that allows them to charge higher prices and negotiate better terms. What is the competitive advantage (if any) in a business? What are the risks of this being eroded?
Power of suppliers: How easy is it for a company’s suppliers to increase their prices thus increasing costs? When there are many suppliers or low switching costs between rival suppliers a company can keep input costs lower increasing profits. We want to know if supplier groups are consolidating. Does the cost of a product/service being supplied represent a small or significant part of the cost of the finished good?
Power of customers: Can customers drive down prices? A small and powerful client base means each customer has more power to negotiate for lower prices. A company with many, smaller, independent customers will have an easier time charging higher prices to increase profitability. We want to know if customer groups are consolidating.
Threat of substitute products: Companies that produce goods or services for which there are no close substitutes will have more power to increase prices and lock in favourable terms. When close substitutes are available, customers will have the option to forgo buying a company’s product, and a company’s power can be weakened. We want to understand if a business faces commoditisation or substitution effects. Conclusion We are committed to delivering superior investment returns to our clients and have a long track-record of achieving this using a high-conviction investment approach we have honed through many years of practice. As described above, we look to invest in cash-generative businesses with clear barriers to entry, visible growth opportunities and attractive industry structures. When we find such businesses, we look to buy and hold for the long-term.
We are committed to delivering superior investment returns to our clients and have a long track-record of achieving this using a high-conviction investment approach we have honed through many years of practice. As described above, we look to invest in cash-generative businesses with clear barriers to entry, visible growth opportunities and attractive industry structures. When we find such businesses, we look to buy and hold for the long-term.
Our investment style at a glance
- Our detailed analytical process begins with identifying companies with strong business models exposed to the drivers of long-term growth, with sustainable returns on capital and run by first class management teams. Our process seeks to find the best of these from the available universe of European-listed equities.
- When assessing stocks for inclusion in the portfolio, we consider a time horizon of 3-5 years and beyond, focusing on business characteristics that can deliver an enduring advantage rather than merely looking at short-term factors/performance as we believe much of the market does.
- The specific characteristics we look at include barriers to entry, meaning factors that restrict the ability of competitors to disrupt a company’s business. These include things like strong branding, the holding of key patents, having efficiencies of scale, and existing customers having high switching costs.
- We carefully examine industry structures, looking for industries where there is no single customer who can drive prices down and no single supplier who can squeeze profit margins – because that means businesses are better able to generate consistent cashflow. Such businesses tend to have the opportunity to reinvest that cashflow for more growth in the future, as well as delivering higher investment returns that are not simply competed away over time.
- Due to our focu