INVESTMENT PROCESS
Well-Defined & Disciplined Investment Process
We follow a rigorous, clearly structured, in- house developed investment process which aims to identify quality companies in which to invest and almost as crucially, the points at which to invest. Our process entails rating a company based on aspects such as management quality, business quality and financial quality. We then establish an overall value rating using our ratings scale. The final rating then drives the level of margin of safety required and therefore, the price at which we are comfortable purchasing this stock for our clients.
Every stock we hold in our portfolios is subjected to this process and then subsequently deliberated on at length amongst the entire investment team. The outcome is a decision taken by the team to either buy, hold or sell the stock.
This process manual documents this investment process.
The Long Term
Many investors talk about long-term, however very few realise how different their views of what long-term can be. Long-term could refer to a period that covers at least one business cycle which typically lasts between 7 – 9 years. A heuristic generally used for long-term in the market, especially when it comes to comparing asset managers, is 5 years.
We like to look at long-term as truly long-term, meaning that when we buy big, our preference is that we will never sell. Only negative information pertaining to quality and asset allocation decisions would ever affect that. There are numerous instruments in existing portfolios that we have been holding and never sold on behalf of clients. We can therefore apply a widely used term to define our long-term approach, “buy and hold”, assuming the fundamentals remain in place.Bonds in our portfolios are generally held to maturity. We continuously review the liquidity and quality of these bonds and a deterioration in these metrics would lead us to reconsider our position. Only in extremely adverse conditions will we consider selling bonds before maturity.For us to follow this long-term strategy, we follow a rigorous,
clearly structured, in- house developed investment process which aims to
identify quality companies in which to invest and almost as crucially, the
points at which to invest. Our process entails rating a company based on
aspects such as management quality, business quality and financial quality. We then
establish an overall value rating using our ratings scale. The final rating then
drives the level of margin of safety required and therefore, the price at which
we are comfortable purchasing this stock for our clients.
Investing as a Team
Decisions around which stocks to buy, sell or hold are
discussed and concluded by the entire team during our weekly research meetings. Firstly, the research
analyst assigned to a particular stock is tasked with conducting adequate due diligence
on the said investment
instrument in accordance with our investment process and with supervisory support
from the relevant
portfolio managers.The research is then presented to the team in the meetings, during
which each team member is offered the opportunity to scrutinise the analyst’s assessment,
including the ratings given to the company under review. Finally, a mutual
consensus is reached over the investment decision, considering our margin of
safety requirements and the team’s comfort over the quality assessment. The involvement
of the entire team in this process allows for greater variety of perspectives.An additional meeting is held monthly, where we assess
the market cycle and major economic variables on both a local and global
perspective and take note of any markers that may suggest evolving market conditions.Our investment process seeks to bridge the gap between
psychology and investing. All too many investors are not cognisant to the
mental pitfalls that await them and the typical biases that arise during the process
of investing. The biases of course exist because of four main factors: 1) An abundance
of information; 2) Not enough meaning to the information; 3) The need to constantly
act fast and 4) Uncertainty around what information should be remembered.We are aware of the typical biases and have in place a robust
investment process that mitigates against these biases. Our cognisance of the
risks of these biases allows us to remain level-headed during times of
unparalleled optimism and calm during times of market- spread pessimism. Part of our mitigation strategies related to behavioural
biases is in us recognising that they exist and following an investment
approach that is based on team consensus, a documented and methodical
investment process and training strategies that attempt to be agnostic to
market conditions.
Margin of Safety
Margin of safety provides us with a safety buffer. We determine this buffer based on our level of conviction about a stock’s quality, after we have put the stock through our quality test. The higher this stock ranks in terms of our rating scale, the narrower the margin of safety we require in terms of the price at which we purchase the stock.
This purchase point is established with the
margin of safety in consideration, as well as the intrinsic value of the
company, which we derive using fundamental analysis. The valuation models are
built in-house and include assessment of key ratios such as Price to Earnings,
Dividend Yield and Return on Equity amongst others. The outcome of this stage
of the process is an idea of whether the company in question is under or
overvalued.
We like to buy when an instrument is
undervalued compared to its historical average or when that same instrument is
cheaper than its comparatives or the market, or a combination of the above. The
sweet spot is when an instrument is priced at lower than its own historical
average, the peers in its sector and the market, without any notable negative
changes in the quality of management or its competitive position. Under such a
rare circumstance we hope that we have cash to start buying.
It must be said that we never try to time
the market but rather focus on our time in the market. There are certainly
periods when we experience extreme market volatility, but we prefer to remain
painstakingly closely aligned to our investment philosophy. This will sometimes
mean that we don’t react by trading, but rather continue to monitor our
portfolios and test them against our market views. This has helped us navigate
through market turmoil in the past.
This will sometimes result in us
underperforming the market and our peers as certain themes gather momentum, but
over the duration of our long-term track record we have learned that sticking
to our principles is more important in gaining an edge over the long-term,
rather than following the crowd and herding! It is also worth noting that we
are not necessarily bargain hunters. You will not find us at pawn shops and
second-hand car dealerships! We are willing to pay for superior performance and
returns if it remains within a reasonable margin of safety, because quality
shields us from failure.
Our cash flow forecasts and costs of
capital assumptions also incorporate a margin of safety.
When it comes to bonds, we are as concerned
with the margin of safety as we would be for equities. Our view on the market’s
interest rate outlook plays a significant role in determining whether a
specific bond’s margin of safety is adequate. Additionally, we assess
instrument duration vs the market and the yield curve positioning.
Our quality test is centered around three
pillars, namely Management Quality, Business Quality and Financial Quality. We
define quality as a business’s ability to stand the test of time and
continuously generate value for shareholders, through predictable and
proven earnings and growth, whilst remaining ethical and a good corporate citizen.
We maintain that a sustained record of value creation, market leadership,
diversity of product and geographical footprint, brand pull and earnings power,
backed by a robust and sufficiently liquid balance sheet, are the
cornerstones of a quality business. The foundation to such a business is of
course exemplary management, another fundamental of our analysis.
Management Quality
Our long-term investment horizon requires that we have full faith in the ability of management to deliver on their promises and successfully manage the companies that we are invested in. In doing so, we have a strong preference for businesses that have a strong track record in business operations and capital allocation, coupled with navigating the moral and legal obligations around Environmental, Social and Governance (ESG).ESG considerations have become increasingly important. Investors are becoming more concerned with the impact of ESG, that businesses have in their respective industries. ESG considerations therefore form an integral part of our assessment of management quality. Management teams should be held responsible for delivering ESG measures and held accountable for it. We therefore place significant emphasis on Governance, as we believe that strong management teams are synonymous with strong Environmental and Social practices.
BUSINESS QUALITY
We look for companies that are set apart from the rest of the crowd. With an ever-changing way of doing business, companies need to be at the forefront of their respective industries. Technological developments have been the driving force in maintaining a competitive edge and companies have had to either adapt or risk being left behind. Being a market leader allows companies to have stronger pricing power which in the end, can lead to higher margins and profitability.Another key consideration is how easily a similar business can enter the market. High barriers to entry make an industry more attractive, with a visible impact on the ability of current market players to continue generating, and growing, sustainable profits. Maintaining a dominant market share and strong pricing power can only be achieved with minimal threats of new entrants. We look for companies that demonstrate cost leadership, differentiated products or services or economies of network.These characteristics define the distinct advantages we look for in companies compared to their competitors.
Financial Quality
Consistent profit generation, healthy margins, high levels of cash and cash generation and sustainable leverage. These are only some of the metrics we look at when assessing financial strength. Ultimately, cash is king. We will always prefer positive cash generative companies as they are better placed to take advantage of valueenhancing opportunities and are better positioned to weather recessions, depressions and increased competition. Perhaps equally importantly, a company unable to generate cash will also face difficulty in paying us as investors our required return on investment.
SUMMARY
In summary, ultimately for any investment/ instrument to be added to our watchlist, it must pass the “quality test”. A company/issuer passes the quality test if we are satisfied that the above matters discussed are to the satisfaction of the Arysteq investment team. An instrument reaching our watchlist does not necessarily result in us adding the instrument to our portfolios. We follow through with a buy only when we are comfortable that there is a reasonable margin of safety based on our valuation.
