Long-Term Value Investing: Strategy, Moats & Portfolio Management

During their recent episode, Taylor, Carlisle, and Ardal Loh-Gronager discussed Long-Term Value Investing: Strategy, Moats & Portfolio Management. Here’s an excerpt from the episode:

Tobias: Tell us a little bit about your investment strategy. What sort of businesses do you like to look at? What’s the geographic range, any industries, just give us a flavor for what you do Ardal?

Ardal: Sure. So, my fund, we’re a global fund. So, essentially, it means we’ve got either the blessing or the curse, you might call it, of the fact that we’ve got the whole investment universe, which is roughly 45,000 listed equities globally. So, the question then normally becomes, well, how do you narrow it down? Well, we have a few ways of simplifying the process. The first, is we divide our portfolio in half. So, on the one side we have our developed markets portfolio and on the other side, we have the emerging market part of our portfolio.

We are concentrated long-term value investors. So, by concentrated, I mean, that we concentrate 90% plus of our capital in 20 names. So, we have roughly 10 holdings within developed markets and 10 holdings within emerging markets. What we found, is that the academic research tends to show that over a five-year rolling period– or sorry, a year-to-year period, there’s very little correlation between developed markets returns and emerging markets returns.

But over a five-year rolling basis, there’s significantly higher statistical correlation. What we think therefore, is that there’s an opportunity to add alpha to the portfolio by rebalancing between emerging markets and developed markets over time. So, that’s the overall portfolio management.

And then, in terms of the businesses we’re looking for– So, I say we’re value investors and what do I mean by that. Well, we’re looking to buy essentially dollar bills for 50 cents. And in addition to that, I think there are a lot of people looking for that thing, but we’re looking for several things in addition to that. So, we’re looking for a business that has an identifiable and defensible moats around it, and that’s coupled with a long runway in terms of future growth potential.

So, businesses that fit this description, we tend to find can grow at roughly 10% per year. They do that through having very good long-term capital allocation policies. So, our portfolio tends to be founder or owner operated first or second-generation businesses, as we find they have a more long-term investing mentality. So, if the business can compound the capital at 10% per year and our dollar bill is valued at 50 cents when we buy it, then over a roughly five-year holding period, which is what we talk about as our ideal minimum investment time horizon of five years, that dollar bill would compound to $1.62, growing at 10% per annum.

We think that over that period of five years, if the business manages to consistently achieve decent financial performance, it’s more likely to be valued in the market at closer to the intrinsic value, which would at that time be $1.62. So, the return on our 50 cents purchase price then in five years would be roughly 26% per year. So, that means our capital doubles every 2.75 years or roughly 3 years. And so, that means that if you invested a dollar on day one, that would grow to $10 at the end of 10 years. So, that’s the journey that we’re on. That’s the target in mind when we’re going through the investment criteria and deciding what businesses would fit within our own portfolio.

We are country agnostic, sector agnostic, but we want to be geographically diversified and sectorally diversified across the portfolio. And then, in terms of the things that we’re looking for individual businesses, we have a roughly 250 question internal checklist when we find a business. The purpose of that is really just to throw up red flags that we’re going to do a bit more research on. And that’s quantitative and qualitative. But if I was to boil it down to the main things that we’re looking for–

So, the one is we’re looking for high returns on capital employed. So, it was Buffett that famously said in his shareholder letter to Berkshire Hathaway shareholders in 1979 that “ROCE or Return on Capital Employed is the primary test of managerial economic performance.” We definitely believe at my firm that that is true to this day. So, we want to make sure that our companies are returning and creating more value than the market in general.

And then, there’s three other points that we cover. So, the next stage is margins. So, we look for above-average gross margin. We think that’s a way of identifying a moat around the business. So, gross margin is the difference between revenue and cost of goods sold, and it essentially represents the difference between what it costs our company to make products or sell its service compared to what it’s able to produce them for. So, it’s the difference between the two.

And then, the third step is the operating margin, which is a cousin of the gross margin. So, here, we’re trying to evaluate the operational efficiency that our businesses operate at, i.e., by looking at how much the business earns after all direct and indirect costs have been deducted from their revenue. And then, the final one, which I actually think I probably should have done them in reverse order, because I’m sure you agree with me on this, is that most businesses don’t go bankrupt, because they’re not profitable. Most businesses go bankrupt, that is a permanent loss of capital for investors, because they run out of cash. So, cash is absolutely key.

So, the fourth thing we look for is– We look at through lots of different ways, the conservative financing nature of our businesses. But mainly, if we were to simplify it down, the current ratio, we want to know how many times over our companies can pay through their current short-term liquidity, the current upcoming costs of borrowing. I would say in our portfolio, typically, we prefer to have zero leverage in our portfolio, because again coming back to that point, I think most companies, even profitable and growing businesses can go bankrupt, and it’s often by running out of short-term cash.

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