We are “quality value” investors, meaning that we look to invest in strong businesses at prices that do not require undue optimism to think that they can produce an attractive return. This is not a controversial aim, but does not convey any detail.
We see both “quality” and “value” as more than just narrowly defined numerical measures, which is how they are viewed within much of the investment industry. We see them as multi-faceted, and use a combination of qualitative and quantitative considerations to form our view of them.
We see “quality” companies as those that earn a healthy return on invested capital without the need for too much balance sheet leverage or financial complexity. We want to own companies that also have a strong and durable competitive position, and an honest and capable management team. These are easier to say than to assess, as they involve subjectivity. There are many secondary factors that we also consider, for example the alignment of incentives between management and shareholders, and the simplicity of the underlying business.
We see both a company’s ability to generate earnings and cashflow, and its balance sheet assets, as potential sources of “value”. Whilst we look at historic valuation ratios, our final assessment is based on forming a view about the future. We construct a valuation model, which produces a “range” rather than a spuriously precise single target price. These models form a framework that forces us to be explicit about why we think an investment is cheap, and helps us to compare their relative attractiveness.
We are happy to own companies with limited growth prospects, provided they have the discipline to send excess capital back to shareholders via dividends or buybacks. Conversely, we like companies with good growth prospects, provided that an expectation of this is not already reflected by a high valuation. We are happy to own companies that do not deliver their earnings smoothly, provided that we think they have the ability to endure for the long term and across entire business cycles.
We see investing as a trade-off between what you pay, in terms of valuation, and what you get, in terms of quality. We believe that many investors place a disproportionate emphasis on the quality of the business, which means that many “consensus” companies look expensive to us. Conversely, we think there are overlooked companies that are higher quality than they might first appear.
For every investment that we make we wish to have a thesis as to why we disagree with the current market price. We are happy to be contrarian, but not for its own sake. Our theses are often based on the opinion that other investors are too focused on short term earnings, or that a company is not well understood by others. This corresponds to a belief that being long term, and doing thorough research, provide us with meaningful sources of investment “edge”.
Our entire philosophy is underpinned by an awareness of the role of uncertainty. We know that our ability to foretell the future is very limited, and that not all of our investment theses will play out as we would wish. We believe that our valuation discipline helps ensure a “margin of safety”, such that even under pessimistic assumptions we are not overpaying for an investment. When an investment doesn’t work as we would hope, we want to understand if and how our views were wrong, and if we can learn from it.
My background was in the “quant” industry, and although it has influenced our approach, we do not make investment decisions based on following an algorithm or rule. We believe that the best investors are objective and structured, and these are characteristics that have been built into our investment process. Despite this we believe that our style of investment contains much subjectivity, and as such human judgement is a part of our process.
When we started the fund, we had no engagement with management and paid no attention to the research of others. Our stance on this has changed from one of outright cynicism, to healthy scepticism. For the smaller companies in our portfolio, we have found benefits from speaking to management, but for the larger companies where we do not have direct access, we see little benefit. We spend more time considering the views of others, and are not shy of plagiarising ideas from those we respect, but will always undertake our own research and form our own views.
Our holdings broadly fall into three categories that we refer to as “core”, “asset based”, and “special situations” based on both the nature of the underlying businesses and our investment theses. Like all classifications, they are imperfect, but provide a helpful lens through which to view our portfolio.
The core category represents our “bread and butter”, which are niche businesses that we believe to be of higher quality than their valuations suggest. They are often operating in cyclical industries whereby their share prices are “anchored” to short term weakness, rather than long-term prospects. They are also typically mid-caps, with a low level of research coverage and understanding.
The asset-based category reflects companies such as banks, energy producers, or miners that are capital intensive businesses that rely on owning a scarce resource and or using financial leverage. We find this area appealing because it has been unilaterally out of favour with investors, which means that it contains some high-quality businesses with comparatively modest valuations. They do however entail a greater understanding of balance sheet risk.
The special situations category represents companies where there has been a “bump in the road”, such as a merger, change of management, or change of strategy. We are attracted to companies that we think are fundamentally sound, but where the current valuation is anchored on concerns about these short-term challenges. These situations often appear to coincide with a rotation of ownership, which creates price volatility as one set of shareholders depart, and a new set arrive.
We typically have 30-40 investments in our portfolio, with the top ten representing up to half of it. We think that this provides sufficient diversification, whilst making us different enough from the broad market indices to have a chance of outperforming them. We do not think our approach is the only way to invest, but it is differentiated, as many global funds have a significant exposure to the more popular areas of the market that we do not own.
This entire approach is underpinned by a culture of humility, and a desire to keep learning.
Matthew Beddall
CEO and Fund Manager, Havelock London Ltd