Enlightened Capital Blog

My Investment Philosophy

My Investment Philosophy

Every great investor has a clear investment philosophy helping them narrow down their investable universe from a possible 630,000 global public companies. Professional investors are typically limited in their investable universe based on their fund’s investment policy which determines which companies are eligible for investment based on geography, market cap, sector, and investment style such as value or growth. However, as an individual investor, I have a great competitive advantage: the ability to invest in any company regardless of its geography, sector, or market cap.

My investment philosophy

Here is my current investment philosophy, which is heavily influenced by great investors such as Warren Buffett, Mohnish Pabrai, Guy Spier, and Pat Dorsey’s excellent work on competitive dynamics across industries.

I seek to generate attractive returns by investing in companies who produce strong returns on capital, with the ability to reinvest capital at attractive rates for a long period of time. Additionally, I look to invest in companies run by exceptional management teams. Finally, I look for companies with reasonable valuations, as even great companies can be poor investments if purchased at an unattractive price. 

Implementing my philosophy

I am currently in the process of building a portfolio using my investment philosophy. This well-defined investment philosophy is valuable as it helps me limit the potential candidates in a portfolio and helps me focus on the areas of the market where I expect to earn attractive rates of return. For example, I can rule out many of the popular software as a service (SAAS) companies, who don’t meet my requirement of generating strong returns on capital with the ability to reinvest capital at attractive rates of return for a long period of time. Additionally, most of the popular SAAS companies trade at unattractive valuations. Similarly, it’s easy to rule out investing in the majority of companies in cyclical sectors such as oil and gas, or metals and mining, given the weak returns on capital over time and low expected returns on capital going forward.

My plan is to build a concentrated portfolio of roughly 10 companies. Running a concentrated portfolio allows me to focus my attention on my best ideas and creates a high hurdle for new ideas to be included in the portfolio. I also expect to stay invested in these companies for a long period of time, at least five years if not more. I approach investing in public companies as a business owner and am not looking for short-term trading profits, but instead to realize attractive returns over the long-term This also helps to minimize taxes and transaction costs, and allows the returns from great investments to compound substantially. As Buffett said: “Our favorite holding period is forever.”

How to identify these companies

To find companies that consistently generate strong returns on capital and can reinvest that capital at attractive rates, I start by analyzing the competitive dynamics of the industry I’m looking at. Specifically, I try to determine if the company I’m analyzing has sustainable competitive advantages driven by substantial barriers to entry, and do I expect those competitive advantages to persist for a long time. In my review of Competition Demystified, I discussed the three categories of barriers to entry outlined in the book: supply advantages, demand advantages, and economies of scale. I’ve found this framework to be extremely valuable for understanding industry dynamics. Here are some of the key barriers to entry in each of the three categories:

1) Supply Advantages: competitive costs and government regulations. Supply advantages can arise from lower input costs and several types of government regulations which limit supply and competition. Lower input costs can arise due to preferred access to natural resources in sectors such as Oil & Gas, and Metals & Mining. These supply advantages allow a company to produce or deliver its products more cheaply than peers. As a result, potential entrants are deterred from entering the industry due to their higher cost structures.

I divide government regulations into two major categories: intellectual property and license to operate/natural monopolies. Intellectual property refers to patents, copyrights, and licenses. In each of these areas, government regulations limit competition for a set period or limit the way competitors can act. For example, In the pharmaceutical industry, the effective life of a patent is typically 7 to 10 years, although patents can be extended for longer periods of time. Copyright protection typically lasts for the life of the author plus an additional 70 years!

Finally, government regulations can create natural monopolies in sectors such as Electric and Gas Utilities, Midstream, and provide license to operate in sectors such as Financial Services. In the Utilities and Midstream sectors, it is almost impossible for new companies to enter those industries given the necessary government licenses to operate. Similarly, incumbent banks and insurers benefit from the high regulatory hurdles preventing new entrants. For example, the top 5 health insurers in the U.S. (UNH, ANTM, CVS, CI, and HUM) insure roughly 47% of all Americans as of 2019.

2) Demand Advantages: customer captivity. This barrier to entry consists of capturing customers based on consumer habits, high switching costs, and network effects.

Competitive advantages through consumer habits tend to be linked to frequent and nearly automatic purchases such as food and beverage products. Buying a Starbucks coffee or choosing a Coke or Pepsi has become habitual for billions of consumers globally creating substantial barriers to entry for Starbucks, Coca Cola, and Pepsi. However, this behavior does not translate over to less frequent consumer purchases such as luxury cars.

In terms of high switching costs, the banking industry represents a clear example. While most banking services are commoditized, customers infrequently switch banks due to the hassle of doing so.

Network effects have become a very power barrier to entry over the past 20+ years driven by software categories such as social networks, search engines, marketplaces, and online gaming. The value of these networks has expanded rapidly driven by Metcalfe’s Law.

3) Economies of scale. Incumbent firms operating at large scale will enjoy lower per unit costs than their competitors. As a result, firms with greater scale will experience higher margins le than their smaller peers due to their superior unit economics. Greenwald describes economies of scale as a powerful barrier to entry when paired with some degree of customer captivity.

Additionally, many industries enjoy multiple barriers to entry creating strong competitive advantages for incumbents. The banking sector exhibits customer captivity through high switching costs, economies of scale, and the regulatory environment limiting competition. Similarly, many Saas companies enjoy substantial customer captivity through network effects, consumer habits, and economies of scale.

Once you’ve determined that there are barriers to entry and that incumbents enjoy strong competitive advantages, you want to evaluate how long that competitive advantage will last for. Figuring out how durable a company’s competitive advantage is extremely challenging. In most industries, returns on capital decline over time driven by new competitors in the industry. As a result, it is extremely important for companies to defend their competitive advantage, to ensure they will continue generating strong returns on capital for a long period of time. All I’ll say for now, is that certain industries lend themselves to much more sustainable competitive advantages over time than others, such as Technology, Healthcare, Aerospace and Defense, etc. This chart shows the substantial difference in sector ROE’s for the U.S. stock market, looking at sectors with at least 50 companies. ROE’s range from 31% for Aerospace and Defense to -8% for Oilfield Equipment & Services.

ROE by sector

Source: Aswath Damodaran data

Management quality

Finally, management quality is critically important. Ideally management has significant skin in the game, (certainly easier for smaller companies), an established track record of strong capital allocation, and a focus on increasing per share value. Management’s primary job is capital allocation (I highly recommend The Outsiders for more on capital allocation). The major capital allocation options include investing internally through capex or research and development, making acquisitions, or returning capital to shareholders through dividends and share repurchases.

Strong capital allocation decisions are what allow companies to grow at high rates over a long period of time and are critical for achieving successful investment outcomes. As a result, it’s important to understand how management prioritizes these capital allocation decisions, analyze how management is being compensated, and then observe how management actually allocates capital over time. Does management indiscriminately repurchase share regardless of the share price, or are they more tactical in their share repurchases? Does the company pursue large acquisitions which typically destroy value over time, or does the company pursue strategic acquisitions to improve the company’s strategic positioning relative to its peers?

Another important aspect to consider is how much skin in the game management has. Does management have a large percentage of their overall net worth invested in the company, so that their incentives are aligned with their shareholders? As I mentioned in my review of 100 Baggers, Chris Mayer cites studies showing that owner operator run companies have outperformed the broader market over time. As a result, this is a key factor to consider when making investment decisions.

Valuation is critically important

A focus on valuation is also extremely important to build in a margin of safety against an unknowable future. Even great companies can go through long periods of weak share price performance. For example, if you bought MSFT at its peak in 1999, it took you 18 years to break even!

MSFT example

There are plenty of other examples following the Nifty Fifty bubble of the 1970’s. You can see the starting P/E and subsequent returns for what were considered the best U.S. companies of the 1960’s and early 1970’s. Although the 20, 30, and 40-year returns are decent for many of these companies, the 10-year returns are awful across the board. I can’t imagine anyone having the conviction to hold those stocks after such poor returns over a 10-year period.

Cheap Nifty Fifty StocksSource: https://fortunefinancialadvisors.com/blog/price-is-what-you-pay-value-is-what-you-get-nifty-fifty-edition/

Valuation multiples are currently at historically high levels driven by the low interest rate environment.

SP 500 P E MultiplesSource: https://www.yardeni.com/pub/sp500trailpe.pdf

As a result, valuation becomes more challenging in this environment. However, as an individual investor, I can afford to be patient. There are no called strikes in investing, and my opportunity cost is effectively the S&P 500. I plan on being patient putting money to work given how expensive the best companies are.

Where do I go from here?

To further improve my skills as an investor, I am focused on increasing my knowledge of other sectors. Professionally I have covered a variety of sectors including Financials (Banks/Brokers, Insurance, and REIT’s), Energy, Utilities and Transportation, which combined make up roughly 22% of the S&P 500. However, that still leaves roughly 78% of the S&P 500 that I don’t have much experience with including large sectors such as: Tech (27%), Healthcare (14%), Consumer Discretionary (11%) and Communications (11%). As a result, I am focused on building my knowledge base of these sectors to expand my investable universe. While expanding the sectors I look at makes sense, I will not compromise my investment philosophy by investing in companies that do not meet my criteria.

I’ll end with another Warren Buffet quote: “What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”

Further Reading:

Competition Demystified
Quality Investing
The Five Rules for Successful Stock Investing
The Essays of Warren Buffett

Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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