Being a boutique doesn’t mean we don’t have access to big
league information. In fact, much of the information we receive is precisely
the same that’s available to every other house. So it is how we interpret this
information and how we make use of it that distinguishes us. Listening and
talking to company management enables us to spot patterns and trends ahead of
published data.
We don’t try to cover the whole market; instead, we focus our efforts on pure
stock selection.The use of investment themes forms a vital part of this
process.These are patterns which we identify in one company or sector and which
act as a guide to success in others.These patterns might be pricing power,
management change and so on. It is on these companies that we focus our hunt.
We start with a company’s top line.We analyse it, question it, reduce it to core
components. Treating a company as a business, we know that sales are the
soundest indicator of underlying value. Earnings per share and other
conventional stockmarket measures can be distorted by accounting treatment and
unsustainable factors, such as cost cutting.
We focus on operating margins and the rate of return on capital employed.We look
at industry margin patterns of the sector concerned - by looking horizontally
at competitors, and also comparing margin dynamics in terms of pressures
exerted by customers and suppliers. Our analysis focuses on understanding a
company’s accounts and the environment in which it operates.
For similar reasons, we analyse a company’s enterprise value – the total of
equity and debt – to assess what price we are paying for a business. This can
highlight the opportunity to release value by restructuring. This is similar to
the way a trade buyer would value a business.
A company with low operating margins, and therefore the potential to improve up
to industry norms, catches our eye. It is often less risky to move margins up
to industry averages, than to attempt to win new customers away from
competitors.
We look for companies that have the pricing power to protect operating
margins.We’re also persuaded by the value of organic growth and free cash
conversion. If excess returns can’t be reinvested in new capital investment,
then we’ll expect management to return excess cash to shareholders.
We seek to establish absolute value and not relative valuations. We challenge
our own valuation metrics against the consensus to determine whether our
position is contrarian and whether we should invest.True investment performance
is driven by positive earnings surprise – companies beating expectations.
Consensus is therefore always our base station.
We talk to company management. Each year, our investment
team meets approximately 500 companies within the UK & Europe.We do not
undertake research site visits as we do not believe them to be a source of
value.
Companies we avoid: those who exhibit overly aggressive accounting; poor or
unsustainable margins; weak balance sheet; poor profit to cash conversion.We
also pay close attention to tax paid as we believe this is a key indicator to
the quality of a company’s profits.
All of this detailed original research tends to direct us to own three main
types of business:
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Clearly undervalued businesses: Under-rated, improving margins, clear
visibility of earnings.
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Businesses in transition: Improving earnings quality, or restructuring; change
not yet recognised.
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Growth at the right price: Organic growth, competitive advantage, pricing
power.
Before investing in any company, we need to see some form of catalyst.We need to
be convinced of the process by which value might be released. For example, the
shape of a restructuring that could enable a lower quality business, with lower
than normal operating margins to improve and move into the quality space -
leading to share price improvement.
Risk management is deeply rooted in our business, not least through our long
experience in hedge funds.The main risk we face is company risk: that the
companies we select will disappoint.We reduce this by knowing each company we
invest in intimately and constantly challenging the purpose for holding it. Our
risk manager monitors each portfolio on a weekly basis and is also responsible
for risk control within our hedge funds. We use an independent portfolio
analysis system to monitor each portfolio.This enables us to understand the
nature of our portfolios versus the market at any time.
Our analysis evolves.We are continually revisiting our initial research on
companies.The decision whether to maintain, buy or sell a position is
influenced not only by our company analysis, but also by the individual client
mandate and our overall portfolio risk monitoring.