Growth at a Fair Price

In this blog, I want to share the investment philosophy and approach that I use for my own investments. I have termed it Growth at a Fair Price.

In my previous blog, Developing your Investment Philosophy, I discussed how you should develop your investment philosophy and approach that is suitable for you; given your circumstances, your knowledge, the amount of risk you want to take and the level confidence that you have in your investing skills.

I also started the blog by stating that “Investing is not easy” and that may well be because I am a bit slow. Even after 25-odd years of investing in the stock market, I still learn something every day about investing. And at times those lessons can be quite painful.

In this blog, I will outline the core aspects of the philosophy that I use in investing. This philosophy and approach has evolved over time, and is radically different to what it was (if I even had a philosophy then) when I started out. It is certainly not fool proof and there are times when I have questioned quite deeply whether it is right or wrong; learnt from that, and adjusted my thinking and approach accordingly (Learn. Invest. Review).

Importantly, my investing horizon is very long term. And, this philosophy and approach works for me over this long-term horizon. Further, given where my own knowledge and skills are, as well as the risk appetite that I have, it is appropriate for me.

Growth at a Fair Price

Broadly, I would categorise my style as Growth at a Fair Price. This involves scanning the market for growth opportunities which I translate into Investment Themes, identify those businesses that can best take advantage of those growth opportunities, establish a value for them and buy them if they meet my valuation criteria and fit well into my portfolio.

Investment Themes

To establish my investment themes, I scan the market for demographic changes, new trends and technologies, macroeconomic shifts and use these to develop investment themes. I’ll explain by way of an example.

One of my favourite investment themes at this moment is in the Energy sector. Take a look at the graph below from the IRENA Renewable Cost database.

From this, you can notice that firstly, the number of Solar photovoltaic electricity projects have increased significantly from 2010 to 2014; and secondly that the cost per kWh of the large projects in this area has also reduced quite significantly. More importantly that some of these projects are producing energy at costs which are at similar levels to fossil fuels.

These cost reductions in solar power will most likely continue as a result of more efficient solar panels and better battery storage technologies. In my opinion, this will have a profound impact on the cost of energy and environmental health (both positively) in the short-, medium and possibly long-term.

Thus an investment theme could be “Renewable Energy Technology Advancements” and I would try to identify those businesses that could benefit from this theme; and these could be providers of the technology or even consumers of energy.

As a guideline, I try to maintain the number of investment themes at any point in time to a range of between five to seven themes. The reasons for this are:

• Having too few themes could increase the risk in your portfolio if you are wrong;
• However, limiting the number of themes, also forces you to be more selective about your investment themes; and
• Lastly, limiting the number of themes allows your portfolio to gain meaningfully when you get the themes right.

Analysis and Valuation

Now once I have identified a number of businesses that could support my investment theme/s, in the next step I analyse and value each of these and make my decision on which businesses I want to buy into. Ideally, I like to choose quality businesses that are fairly valued (and hopefully undervalued).

Typically, I would do a high-level analysis on each of these businesses, looking at both quantitative and qualitative criteria. From a quantitative point of view, I will start by looking at the following key metrics:

• Market Capitalisation – Is this business worth its market capitalisation, how does it compare to other similar businesses, how does it compare to other businesses in other industries?
• Price to Earnings (PE) ratio and Forward Price to Earnings (FPE) Ratio – Does this business look cheap or expensive from a PE or FPE perspective? Are there any anomalies resulting in a distorted PE? If I put certain revenue and earnings projections based on my investment theme/s how does this share look like from a PE valuation point of view? How does it compare to other similar businesses and dissimilar businesses?
• Dividend Yield – What is the dividend yield from this business and how does it compare historically? A healthy dividend yield can provide a lot of confidence in a business and also provide regular and growing income to the portfolio. Is there a risk that the dividends could decrease and what does this do to my income objectives?
• Discounted Cash Flow (DCF) – This is when it starts getting a bit tricky, because I have to make certain assumptions on projected cash flows and discount rates. Here, I would build out some scenarios and estimate a valuation range for the business. Again, how does this compare to the market valuation of the business? Is there sufficient room for a margin of error? I specifically try and identify any inherent biases that I may have in making my assumptions, which is very difficult to do.
• Net Asset Value (NAV) and Price to Book (P:B) – what is the net asset value of the business and how does compare to the current price of the business? At what P:B value has it been a good value to buy into this business, historically?
• Margins – What is the gross and net margin of this business? Is there room to improve or is there risk in these margins? What can the business absorb if conditions get bad? Is the business scalable? What would happen to margins if there is growth based on the thematic trends we identified earlier?
• Debt to Equity – Is this business over indebted or over-leveraged? What interest rate and currency risks are there in the debt?

Whilst the above is not comprehensive, it does provide an indication of whether a business is fairly priced or not. Specific industries may also have certain more pertinent metrics that I would include. This can warrant a more detailed analysis of a business before you make your final decision of whether to buy or not.

From a qualitative point of view, one is assessing the competitive edge that the business has, what are its barriers to entry, how do you rate the management of the business and is it a business that attracts talent? What intellectual property does it own? How will it benefit from the thematic trend that we identified earlier? What risks does it face and how does it mitigate those?

At this stage, I look to break the case of buying the business. What could go wrong? Are my assumption correct, or too rosy? Ideally, I would speak to someone who has a different view to me on that business, or read alternate views on the business from other analysts. Am I missing something?

These will all provide me with a basis to make a decision on whether I should be buying this business or not.

Portfolio Management

The final step in the approach that I use, is to make the portfolio decision. What does the current portfolio look like? Do I have sufficient funds available to buy this business into the portfolio? What adjustment would I need to make to the portfolio (e.g. sell something in the portfolio)? After these changes, what would the portfolio look like? Do I have the right balance between the different themes? Do I have the desired level of diversification and concentration in the portfolio?

One of the guidelines I use in my portfolio decisions is that of a 12-share rule. I try not to be invested in more than 12 businesses at any point in time. This provides me with the right level of diversification and concentration in my portfolio. It also helps to force me to make decisions to sell (something I am generally reluctant to do) when I have assessed a new business to include in my portfolio. I try to have a very good understanding of those businesses that I am invested in.

Finally, only after these questions have been considered, do I make the final decision of how much to buy of the business that I decided to buy into and what changes to make in the portfolio. Typically, at this stage, I would develop a strategy of how I am going to make those buys and sells, i.e. is it all in one go, or do I stage the transaction over a few days or even a few months.

I told you up front that Investing is not easy.

Concluding remarks

So the portfolio has been set up now. All that is left is to give the portfolio the opportunity to perform. If you have a high conviction that your investment themes are correct and that the businesses that you have acquired are the right ones then you should give yourself and your portfolio the benefit of the time to let the portfolio perform. I try not to tinker too much with the portfolio after this, but I will learn new information as time goes by and as the world around me changes, which I will use to re-assess my decisions and make appropriate adjustments to the portfolio.

I will measure the performance of the individual holdings as well as the portfolio as a whole on a regular basis. This gives me the opportunity to check back on whether the performance is due to the reasons I identified when I decided to buy into that business or some other reason. Here, I try to be brutally honest with myself and use this as an opportunity to hone my investment philosophy and approach.

So there it is then, Growth at a Fair Price. Identify key investment themes, analyse and value businesses that support those themes, assess the impact on the portfolio, review performance and re-assess investment strategy. All the time, I am continually looking at ways to further develop and hone my investing skills, through my own experiences and through learning from master investors.

Sabir