Introduction

In the long run, our performance is entirely a function of the decisions we make. As we are not practicing a “black-box” approach to investing, it is important for our clients to understand and appreciate how we make our decisions.

Underlying any systematic approach to investing, there’s an explicit or implicit investment philosophy, which dictates how one should make investment decisions. The more explicit and solid this philosophy is, the more useful it will be as a validating or rejecting stock-picking tool.

At the end of the day, an investment philosophy is a theory supported by evidence of success. The word “theory” is often mistaken with the word theoretical, which means limited and speculative. We are not interested in hypothetical concepts, so we leave the theoretical work to Nobel-prize aspiring economists. On the other hand, a theory essentially links cause and effect, and is therefore very practical as it dictates what actions to be taken in order to achieve desired results and avoid undesired ones. As such, any investment philosophy is essentially a prediction tool, so one better make sure it is a robust one.

 

Absolute vs relative returns

There is an incredible amount of fuzzy thinking within our business regarding absolute vs relative return focus. Simply put, the distinction comes down to whether the fund compares its results with an index or a fixed benchmark. Most people who disagree with a relative return focus argue that "you can't pay your bills with it", thinking "what good is it if your fund is down 'only' 5% when the index is down 10%?"

This way of evaluating performance is by nature short term and therefore probably flawed, obviously depending on what the fund is promising to achieve. If one believes, as evidence clearly suggests, that a broad index will produce positive results over time, then a focus on beating that index, i.e. relative performance, must logically produce good to great rewards over time. In fact, returns should be similar to an absolute return focus. However, relative focus can change the behavior of a portfolio manager to concentrate more on short-term relative performance due to the career and business considerations resulting from underperformance. More focus turns to the benchmark, which the manager has not actively invested in, because it will define the progress, and less to the chosen active positions actually in the fund. We concentrate only on position-based fundamentals that will drive absolute returns.

Therefore, we have chosen an absolute benchmark for clients. In our way of thinking, this is the only way an investment manager can really earn his keep.

 

Broad mandate

One of the definitive characteristics of our philosophy is our broad mandate, which enables us not only to invest across geographies and sectors, but also across capital structures. The reason this is crucial is that we are never forced to be in any sector or geography, but are free to pursue opportunities wherever they are offered. The most powerful tool of the fundamental investor is the choice and the ability to not invest in an opportunity.

When speaking about our broad mandate, the following question inevitably comes up: “How do you keep up with all varied influences on such massive body of potential candidates?” Our answer is straight forward but perhaps disappointing to some: “We can’t and we don’t.” We consider our mandate to be the permission to choose investments from such a broad field of opportunities – not a requirement to know “everything about everything”. To attempt to do so is counterproductive.

As generalists, we aren’t specialty experts in anything, but we perceive precisely this to be our edge. From our perspective as investors, all stocks are inevitable in the same business, which is to compete for our capital. And our capital will at any point in time be committed to those which, according to our analysis, offer the best risk-adjusted return, notwithstanding whether it’s a cement- or a telecommunication company, in Austria or New Zealand.

Having spent most of our time as global generalists, we have come across investment ideas from the full spectrum of the markets and sectors. This has helped us to construct mental models to be able to invest successfully across the whole spectrum. In fact, we sometimes come to very different conclusion than people who possess far more knowledge about a specific sector, simply because of our comparison mechanism. The fundamental value creation process of companies and valuation frameworks does not vary across sectors, so the crucial factor is to be disciplined about when and where to invest.

 

Process vs (short term) outcome

So what is our investment philosophy? We view the capital markets as complex adaptive systems whose short term movements are beyond anyone’s true understanding because there are so many varied inputs to the buying or selling decision. Therefore, underlying our investment philosophy is a focus on the investment process leading to our decisions rather than the short term outcomes of those decisions, good or bad. If the investment process is sound, the good outcomes will over time more than compensate for the bad ones. Therefore, in any short term period, we are neither going to congratulate ourselves if we do well nor kill ourselves if we do poorly. As long as the fundamental story is intact, the longer term will tell the true tale.

 

Long term (business-like) investing

It follows from this process-orientation that our approach is long term, and as such linked to the development of the underlying businesses to which our investment (equity- and/or fixed income security) is linked. This is what one calls “business-like” or cash buyer investing, where whatever the business does the stock will eventually reflect.

One clarification: Many confuse a long term investing approach with long term investment. The former is a mind-set applied to fundamentals during our valuation work while the latter is ultimately a function of how long we have to wait for our long term thesis to work out. So although they might coincide, they don’t have to. Ideally, our holding will get re-rated quickly (e.g. through a takeover bid for our stock) so that we can reinvest the proceeds into other interesting ideas and thus make our capital work harder for us. This ideal situation will however necessarily increase the turnover in the fund, and give the erroneous impression that we aren’t long term in our thinking. Therefore, investors should realize that our portfolio turnover is not the cause but the effect of how our investments turn out.

 

Fundamentals vs expectations

Another core part of our philosophy is a clear understanding of and distinction between business fundamental and market expectations: the capital markets are discounting machines and thus set the bar for investment performance through the pricing mechanism. It is only when these expectations (the bar) are exceeded by fundamentals that the investor can count on above average risk-adjusted performance – simply put, we pay cents for what we analyze to be dollars of assets. The market ultimately defines the price and we decide where it should be bought and eventually sold for it now-recognized value as a business.

Therefore, there is much more to investing than simply “buying good businesses and avoiding bad ones” as good businesses can be, and often are, terrible investments due to elevated expectation reflected in the price of their securities. Thus, to us, the most important question in investing is “what is already discounted by the markets?” Without knowing where the expectations are, it’s impossible to have a view of how and when these expectations - and thus the share price - will change, hopefully upwards. So our job as investors is to evaluate the risk/reward characteristics of every situation based on the fundamentals and expectations at hand, which is why valuation is the most crucial part of our investment process.

 

Approach to risk and margin of safety

While investment performance is readily measurable by a single number a posteriori, it’s clear a priori that prospective return must be weighted against risk, thus the term “risk-adjusted return”. As the saying goes: In order to finish first, you must first finish.

A clear definition and understanding of “risk” is a central part of understanding our approach. Preferring to be vaguely right rather than precisely wrong, we don’t see risk as an exact number but rather as a concept. To understand risk, one needs to first understand uncertainty: Uncertainty is when more things can happen than will happen, which is always the case when looking into the future. Risk is the negative outcomes within this spectrum of potential outcomes.

When related to investments, risk measurement is about possibility of suffering permanent capital impairment, and the question becomes if and how we can quantify it. To us, the answer is entirely dependent on the investor’s time horizon. If the money invested is needed for other purposes next week, volatility (Beta, tracking error, draw down etc) is the correct focus. For the long term investor on the other hand, risk is instead defined as simply getting less than what you paid for it, i.e. permanent capital impairment. In other words, in investing, getting only what you paid for isn’t a good deal. Therefore, the only way for us to systematically try to minimize risk is by paying a whole lot less than our conservative estimates of intrinsic value, thus establishing a margin of safety. Again, this is why valuation is so instrumental to our investment process.

Considering the above, we always focus on the downside first and, only if satisfied with what we find, turn our focus to the upside potential. The reason is that we look for ability to withstand adverse outcomes if we are wrong. In other words, if our estimated worst case scenario is already expected/discounted by the market, our downside is well protected even if that negative outcome happens. That is the “dark side” that stands in contrast to the one we envisioned as most probable scenario. Scenario analysis is thus an important part of our work.

Finally on risk, standard economic theory is based on a positive correlation between risk and reward, so that the only way of making more money is to risk losing more money. This is certainly true in some circumstances, such as when employing financial leverage, which we will not do to a meaningful degree. However, we can’t logically apply that as a general rule simply because if risky investments consistently produced higher returns, they wouldn’t logically be considered risky. On the other hand, there’s to our knowledge no risk-free way of consistently making money. So again, risk is a direct function of the price one pays: any security is a bargain at one price and very expensive at another - and this insight illustrates why it neither makes sense to marry or hate a stock. At the end of the day, the less you pay for a security in terms of its intrinsic value the more the potential upside and the lower the potential downside and vice versa. Thus for the long term investor, if anything, there’s a negative correlation between risk and reward.

 

Shorting

A short position on its own obviously requires a conviction level much stronger than for a long position. A short position often illustrates the different time flow characteristics displayed by positive and negative news. Good news arrive sooner and in an orderly fashion while bad news comes to the markets in bursts as there is always more incentive to suppress or deny bad news. Investors must be prepared to be patient and unemotional as they wait for the expected negative news to seep through and affect stock performance. Given the often unpredictable and rapid pricing of negative news, timing and sizing correctly of one’s position are more important on the short side than on the long side. Also, one should not forget that nearly all participants in the financial system have a vested interest in the price of stocks going up so short selling is best fitted for contrarians. As a consequence, little overall investor effort is deployed in shorting, which yields a much less crowded space to pursue opportunities.

With these considerations firmly in mind, the fundamental work to short a stock is much similar to the work necessary to take a long position. The same investment process and method can identify weak business models, elevated expectations, upcoming adverse events and hidden liabilities with the ease that they are accustomed to finding the mirror opposite attributes for their long positions.

We use shorting primarily to optimize the portfolio risk-adjusted return structure. By distilling down the positions by avoiding risk we do not want to take, it has a similar effect as buying insurance on specific part of the fund’s capital. We also expect to create positive return from position-specific negative opportunities.

 

Portfolio construction

Based on our definition of risk as permanent capital impairment, it follows that the merit of each investment is based on its risk/reward characteristics. As an extension of this philosophy, we construct our overall portfolio on a risk-adjusted return basis, which means that the investments should have the highest amount of upside potential compared to downside risk, probability adjusted for each scenario. This might sound like an exact science but it isn’t! Another way of stating this is that we strive to have the fund invested in the most undervalued parts of our investment universe at all times while avoiding the fairly-valued parts and considering shorting the overvalued parts.

Obviously, if two or more assets are equally undervalued, we buy all of them as it doesn’t pay on risk-adjusted return basis to take specific bets. On the other hand, the cheaper any one asset, the more of the fund will be allocated to it to achieve the best result, again on risk-adjusted return basis. Thus, the level of concentration or diversification in the fund won’t be fixed, and at any one point should and will be determined by the number of attractive investments available and the relative attractiveness between them, always using common sense and prudence as guidance. We are very aware of secondary concentration risks however, and we are prudent about fundamental driver exposure (real estate, oil, etc) of the overall fund.

 

A word on being contrarian

We do not call ourselves contrarian just to simply stand out from the consensus crowd. It is our belief that being a contrarian is logically necessary for long term out performance – if one is going down the same path as everybody else, one’s result can’t be expected to be materially different from the average. However, being contrarian just for sake of being different isn’t sufficient for long term success. If the consensus appears to be right on a risk/reward basis, there’s no reason for being contrarian. The simple truth is that it is only when one is right when the consensus is wrong that outsized risk-adjusted returns are possible.