Investment Selection Methodology

2017-01-25T05:39:18+00:00 June 20th, 2016|

Over many years of investing, one develops an investment philosophy and approach that you start feeling comfortable with. You know that it is not risk free, but you are confident that it gives you a framework for making your investment decisions. It’s also not cast in stone, so you are continuously making adjustments to it as you gain experience in the markets and you hone your investing skills.

In this blog, I will outline the methodology that we use in investing. I must stress that investment styles differ significantly and one can find many counter arguments for any given strategy or style. What is important is that you should be aware of the investment philosophy or style that you are following at any point in time and you should only deviate from this in a deliberate and considered way. You should follow a style because you are comfortable with that style. Similarly, through learning and experience, you should adjust your style accordingly; but be deliberate about this adjustment or change in style. You should give your preferred philosophy the time to mature, rather than chopping and changing. Remember that you are in this for the long-term, and investment cycles play out over a very long time.

Before I go into our Investment Selection methodology, I want to stress the importance of learning, and learning through experimentation. Use every opportunity to learn: Why did a particular investment pay off? What assumptions did you make, and were they in fact the reasons for success or failure? Was there an element of luck (good or bad) in your call? What will you do differently from here on?

The matrix below summarizes how we choose to invest in businesses:

matrix

 

The Price Continuum

Let’s start with how we determine whether a share price is high or low. A price is high or low relative to the intrinsic value of a share or company. To determine this, we look at the following:

  • Market Value: what is the current market value of the company? How does it compare to its peers? If the market value was immaterial with respect to your financial circumstances, would you buy that business?
  • Earnings: What are the earnings of the company? How stable or secure is the earnings, i.e. are these quality earnings? Is the earnings real, i.e. how does it compare to the cash flow of the company? We like companies with good quality earnings that are reflected in the cash flow of the company. One of the measures that we look at to determine quality of earnings is the gross and net margins of the company.
  • Current Price:Earnings Ratio: what is the current PE of the company? Is there some extraordinary items that either inflate or deflate the PE? What is the adjusted (for extraordinary items) PE? How does it compare to the historical PE of the company? How does its stack up against its peers?
  • 3-Year Forecast: attempt a 3-year forecast of the company’s growth prospects. This is where you would take into account the analysis of sectoral and demographic trends that we discussed in the last section, if the company is ‘in-the-zone’ of the investment themes, then you would expect a higher than normal growth rate.
  • PEG Ratio: we love companies where the Average 3-year growth forecast is greater than the Current PE; what is termed as the PEG Ratio. When the PEG ratio is > 1, in general we are buyers, when below 1, we are sellers, and almost definitely not buyers. In fact, in our experience, 10-baggers, i.e. those shares that grown to 10 times the value we originally bought them for, are the shares when the growth rate extends over longer than the 3- year horizon we originally looked at. Forecasting growth is not trivial (nobody has a crystal ball) though and hence we look at some of the other metrics in this section as well.
  • Price to Book: the price of the share versus the net asset value of the share is also a good indicator of value, especially when compared to peers and the company’s history.
  • Return on Equity (ROE): ROE is a great indicator of whether a company is efficiently run or not. We tend to favour companies where the ROE’s are generally, but reasonably higher than peers
  • Gearing: gearing helps ROE, but too much gearing introduces risk when business doesn’t go as well as was anticipated.
  • Dividend Yield: we tend to favour companies that pay dividends, but do make exceptions to this for companies that are on a steep growth trajectory and require capital for expansion and they pay low or no dividends;
  • Risk: we also like to understand whether companies are reliant on specific commodities or currency rates. Whilst we do not say that we will not invest in these companies, we are sensitive to when these commodity prices or exchange rates turn and are quick to get out of these investments. These we prefer to trade or ride through a cycle;
  • Sentiment: management sentiment in a company is also a good indicator of whether we should be buying or selling. We prefer positive, but realistic sentiments from management.

 

The table below shows you how we summarise this information and we use this to determine where we assess the Price of a company is relative to how we value the company, i.e. on the Price axis of the Price Value Matrix.

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Whilst the above table does already give one a sense of the quality of a company, we also assess the following to determine where we place the company on the Quality continuum:The Quality Continuum

  • Industry: is this one of our preferred industries determined from our sectoral analysis; is it cyclical;
  • Management: how do we rate the quality of the company’s management and people; is management aligned with shareholders; is this an owner/manager company?
  • Brand: does this company have a market leading brand; does the brand capture the sectoral trends that we identified;
  • Innovation: is this an innovative company; can its innovations be used beyond SA; can its innovations capture greater market share and higher margins?
  • Strategy: what is the strategy of the company and do we buy into this, does it align with our sectoral trends, is the company growth oriented and does it have legs left in its growth?

 

So, what we have described above is our philosophy and methodology for learning about investing, valuing and assessing the quality of companies that we want to invest in and finally placing that company on the Price Quality Matrix.

 

Where we assess a good quality company at a low price relative to its intrinsic value: we BUY that share/company and in fact may also take a higher than average position in that company. Quality companies at good prices relative to their intrinsic value, are very hard to come by and therefore when the opportunity comes you must take full advantage of this. These opportunities come when times are bleak and the market is very bearish. You also will need to have some patience during these times, as it may take a while for the bearish trend to reverse.

 

We AVOID poor quality companies that are assessed to have high prices.

 

Most times however, we find that the companies that we want to invest in, i.e. high quality companies, are in fact priced high relative to our valuation of its intrinsic value. This puts us in a quandary if we do not have any holdings in that company. If we think that the price is not too high and we are in a bull market, we will invest in those companies, but in small chunks. These generally have paid off in bull markets; but have lost us money when the markets turn bearish quickly. We do tend to HOLD these counters if we are already invested in them if we already have them in the portfolio. We may lighten our holding if the position is very high as a percentage of the portfolio.

 

At times we may TRADE in lower quality companies that may offer value over a short period of time; but these tend to be small bets over short periods of time with strict stop loss limits.

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