In my last post, I discussed the macro issues and narratives driving the economy. Market volatility has continued and, in addition to an extended trade war, US markets are now also concerned with rising interest rates, creeping inflation, and an inverting yield curve. There will always be news that creates market concern, but it is usually something unforeseen that impacts investors the most. And for that reason, it makes sense to dedicate this post to detailing our investment strategy and process, which emphasizes understanding the individual companies rather than the broader economy. The investment process focuses on investing in outstanding companies at reasonable prices and reasonable companies at outstanding prices. If we are invested in great companies and buy at great prices, then these investments will inevitably withstand any storms, and our investments will prove profitable.
Our fundamental view on investing is that every investment we make is an investment in a real-life, operating business. When we purchase a stock, we are buying much more than a piece of paper. We are buying a percentage ownership in the business and the right to a percentage of the earnings of that business. The stock will do well or poorly because the underlying business does well or poorly. I founded Richie Capital Group because I realized that my career experiences have provided me with distinct advantages in identifying superior businesses. Each career step has added tools to the toolkit:
- Venture Capital – Reading and assessing hundreds of business plans for emerging businesses.
- Strategy Consulting – Providing strategic advice to management teams seeking guidance implementing new technologies or entering new markets.
- Investment Banking – Advising CEOs seeking to raise capital, sell their companies, or buy their competitors (Mergers & Acquisitions) taught valuation techniques and provided insights into how operators assess value in businesses.
- Investment Management – Working in a professional investing environment honed investment research and portfolio management skills.
My electrical engineering degree assists in understanding technologies and technology companies down to the fundamentals. And after mastering college courses on such arcane concepts as semiconductor doping techniques, I can feel fairly confident when I am expanding my knowledge into areas where I was not trained such as chemicals, carbon black, and chemically modified cyclodextrin[1]. My Wharton education taught me the language of business, finance and accounting, but my education is ongoing, as I have committed to becoming a lifelong student of the process. The continuing education is one of the aspects of this business that I enjoy most. All of these experiences are leveraged to improve the stock selection process and make more astute investments.
How Do We Profit?
After identifying a business, the first question is “How will we generate a profit from this investment?”
Our portfolios are comprised of companies that fit into one of two categories:
- The company is a Market Leader or Market Maker – the best in their category or they are forging new terrain. They have customers who are fanatical about their products or the customers have limited alternative options. These are the outstanding companies that we buy at reasonable prices. We refer to these companies as “Franchise Players,” and we expect them to continue to grow, innovate, and lead for many years.
- The company is somewhat unloved, perhaps misunderstood, or undergoing significant change that has caused investors to shy away. These are the reasonable companies that we purchase at outstanding prices. We refer to them as “Orphaned Companies” and, orphans need love too! At the right price, these investments can be very attractive. We make these investments and wait for the market to recognize the value.
Dozens of companies are reviewed before a handful are deemed suitable for further investigation. Identifying these unique and scarce opportunities is challenging but, over time, pattern recognition makes it easier to identify interesting opportunities.. In all cases, we stick to companies that operate in industries that we know and understand or where we believe we can gain competence through diligence and study. Once identified, we conduct a deeper dive.
Company
The deep dive consists of understanding the business, industry and market position for the company. We want to understand why the market has discounted the stock or underestimated the potential market opportunity.
- What convinces us that the market is wrong and that we are more than likely correct?
- Does the company have a defensible moat to protect the business, and for how long?
- What are the future opportunities for the company or product?
- Are customers so fanatical about the product or so locked into the ecosystem that the company can raise prices when they need or want to?
Management
Warren Buffett has been quoted as saying that he likes to invest in “a business that’s doing so well an idiot could run it, because sooner or later, one will.” This is a reasonable thought process; however, we seek out companies that have Outstanding Leaders at the Helm. It’s important to assess management to understand if they are honest and able. What messages do they convey on their earnings calls? Are they implementing an effective strategy? Are they practical, opportunistic, and flexible capital allocators seeking to maximize value for shareholders? The right management team can navigate during challenging conditions and outmaneuver the competition.
Financials and Valuation
We review the financials to assess the current health and valuation for the business. This analysis can consist of everything from reviewing the last few years of financial reports to building a full financial model to understand how money flows through the business and where the key points of leverage are in the business model. For our investments, cash flow and cash generation ability are always more attractive than profits….
From the financial analysis, we can get a sense for the intrinsic value of the company using relative and absolute valuation methods. This provides us with a firm understanding of the potential upside and downside for our investments. In determining valuation, calculating a singular numerical value is a crime of false precision, as a value calculated to the second decimal place does not prove that an assessment is more accurate. Instead, estimating a general range for the value of the business and comparing it to the value the market is currently assigning is significantly more useful.
Investment decisions are finalized by reviewing an investment checklist which reminds us of items missed on previous investments and ensures that we have completed thorough due diligence.
Our process focuses on the company, management, financials, and the asking price – typically in that order.
In summary, that’s it. But understand that this is a very high level assessment of our process. Each of the categories outlined could be expanded into pages of details. Concepts such as risk, portfolio sizing, sector allocation, holding period, and market cap weighting are also important but not detailed in this short summary. We believe that this process allows us to outperform the broader market by investing in individual companies with limited concern for macroeconomics. The investment process is unlikely to change over time, but it will evolve as we continue to learn and grow.
[1] For one of our holdings, it is a sugar molecule that optimizes the solubility and stability of drugs.
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