Twelve months ago, I published an article called 20 Firms For 2020. In it I outlined 20 firms that I thought were great long-term investments, using my selection process for “high quality, high growth” firms. This approach has worked out very well, with the 20 firms beating the market by 20% on average over twelve months, and 14/20 firms outperforming. That’s a great result, and worth digging into. I explain how I did it in this article, and I draw some lessons that other investors can use for their own selection process.
Value creation over valuation
I invest, rather than trade, so the focus of my analysis is how rapidly the firm is creating value, as value creation is the primary source of long-term shareholder returns. The chart below, which is based on data from 2005-17, shows this graphically. Value creation, which here is represented by EBITDA growth, becomes a more important driver of shareholder returns over time. This means that as our investment horizon extends beyond one year we should focus our attention on how rapidly a firm is creating value rather than trying to time the best valuation entry point based on any specific catalyst.
Chart uses EBITDA as a proxy for cash flow and value creation as historical EBITDA forecasts are more readily available than my preferred metrics
I take this long-term approach partly because I’m good at this kind of analysis – more on that below – but also because there are more opportunities to beat the market when we approach the task this way. I believe that it’s much easier to beat the market over the long term than the short term as equity markets are reasonably efficient over periods of six months or less as the armies of professional analysts who cover each firm’s every move compete away potential for alpha.
Focus on a firm’s competitive advantage
My first step for assessing a firm’s potential to create value is to research and understand a firm’s competitive advantages over its peers and the potential threats to these advantages. Competitive advantages lead to what Warren Buffett calls economic moats. I generally seek out firms with advantages that allow them to provide a unique customer offer. For example, Alphabet has the Google search platform that attracts users who view the ads on it, and Amazon has cost advantages built on scale leadership for their eCommerce & AWS businesses. Such advantages help the firm grow the business while still generating high returns on invested capital for their shareholders.
But these high returns on capital are also attractive to competitors, so I actively seek to understand potential threats to this firm’s profitability and how vulnerable it is to such threats. When doing so I look for common themes of how the strategic landscape is evolving in different industries to assess how such new developments may threaten the strategic position of the firms that I’m considering investing in. In the earlier article I discussed how the trends of superabundant capital and tech-enabled business models are re-shaping the competitive environment in many industries. I’m still focused on these themes, and others including how, in today’s information age, cellphones act as WOMD (Weapons of Mass Disclosure) that can be used to expose companies that engage in unsavory business practices (e.g. Facebook’s recent troubles and United’s policy of prioritizing staff travel over paying customers’). I will write more about these trends and their implications in the coming weeks.
Use cash flow – it is king (still)
Yes, it is an oft-quoted maxim, and for good reason.
The second key part of forecasting value creation and another contributor to my performance comes from focusing my analysis on the right target: I use cash flow to equity shareholders as my primary metric for assessing growth and valuation. My approach is similar to Warren Buffett’s metric of “owner’s earnings” that he described in his shareholder letter from 1986, except I focus on cash flows not accounting earnings.
I use this cash flows as it’s the most direct measure of the value that a firm creates for shareholders. Experience has taught me that using alternative metrics such as EBITDA, which has the advantage of being more widely available, risks masking critical differences in the capital intensity of a firm’s growth, the value that the firm is creating for shareholders, and therefore the likely returns from owning shares in the company.
I will expand on this approach in future publications.
I don’t restrict myself to any region or sector, so when I saw attractive opportunities in high quality China-focused stocks I added 10 of these firms to my list. The Chinese stocks generated returns of 43% on average, vs 28% for the remaining firms. The market returned 16%. While the opportunity to own high-quality Chinese stocks has receded for now – I sold many of my Chinese holdings late last year – the lesson is that investors should seek out such opportunities and take advantage of them whenever possible.
This is easier said than done, of course. While I’m naturally inclined to be more of an expert-generalist than a sector-specialist, and I’ve fostered this inclination in my career, I realize that many investors feel more comfortable in the segments of the market that they know well and they are (rightly) cautious to invest outside this area of expertise. I believe that such investors should try to diversify their skills and expertise by adding more diverse investments over time. To do so investors should seek help from others with the expertise you currently lack and start at a small scale with a plan to grow these investments over time as you become more comfortable. Think of this as investing in your investing process.
In my own investments I cast my net very broadly to assess the possibilities across all sectors and all countries. I do favor an investment style – preferring high quality, higher growth firms – but I also deploy some of my capital in deep value, special situation opportunities such as Valeant, when I find such opportunities. Investing in both growth and value situations helps to diversify my risks within my portfolio.
Compare potential investments to the market
My final lesson relates to another trait that I think is sorely missing from most equity analysis: an explicit comparison of a potential investment to the benchmark alternative, which is to buy a cheap market-tracking ETF. I believe all equity recommendations should clearly state why that firm is a better investment than buying the market, and I do this exercise for all my potential investments.
In most instances when I’m investing in a high-quality business I search for cash flow growth at a reasonable price. We had that with these 20 firms, as I expected them to create value at a rate that was ~10% p.a. faster than the market, and at the time these firms were available for a similar cash flow multiple to that of the broader market. I viewed this “portfolio” of investments as a reasonably safe bet, given these characteristics. They would outperform the market unless my cash flow estimates were way off or their valuation multiple crashed due to some unforeseen macro event.
Where to from here?
One year on, most of the 20 firms remain well-placed to continue to create value for their shareholders. The 2020 firms should grow EBIT by c. 22% annually, vs. growth of 12% for the market (based on analyst consensus estimates). But the valuation of the 2020 firms have increased relative to the market, such that they’re trading at a 15% premium on EV/EBIT and in-line on a free cash flow basis (4.2% and 4.3% yield respectively).
I believe that investors could seek higher returns by selling some firms and buying others that are more attractive investments at this time. I will explore these ideas in the coming weeks.
Note: This article was originally published on Seeking Alpha on April 2, 2018.