#0 The Journey of Compouding - My Investment Phylosophy

All great investors have defined their investment philosophy in one way or another (I personally love the Three Legged Stool from Akre Capital Management).

Reviewing the newsletters I have written since I started back in July I have realized I have published research articles on various companies, my opinion about some sectors and some other diverse topics. However, I haven’t described what I look for in an investment, my thinking process and philosophy.

Hence, I believe I need to write about what my investment philosophy is based on and which is my framework. In today’s newsletter I will try to compile all of this to provide a holistic view on the whole process and investing approach I follow.

Investment philosophy

I consider myself a value investor - forgive the redundancy - with long-term focus. This brief statement might look simple at first sight but it comes with many implications.

Investor

I am an optimist individual with biases who believes the efficient market hypothesis (EMH) is wrong. 

Firstly, let’s start from the end. I believe EMH is wrong because prices not only reflect all information available but also expectations (constituted by data and irrational belief). However, considering now that price is only reflecting the available information, market agents involved in pricing every stock are individuals with difficulties to access the information, process it and make a good use of it. Moreover, would individuals with the ability to successfully process the available information be able to capitalize on the mispricings? For example, regulations or capital availability might be an impediment.

Secondly, to reduce the impact of my biases in my decisions I follow a strategy and support tools. Some flexibility is possible under the right rationale but it cannot become the rule.

Finally, my optimism is reflected in the guiding principle that I build-up my portfolio with low risk companies (at least IMO) but the diversification or weights are not made to withstand a black swan. Also because as it is a black swan I do not know if it would affect only one company or the whole portfolio.

Value

Value is a broad term which is usually presented as the opposite to growth. Growth is part of the value equation. The opposite of a value stock is not to a growth stock but an expensive one. Both, buying average business at cheap prices and great business at average prices are value. My philosophy and strategy is to focus on the 2nd ones, without neglecting the possibility of jumping into special situations.

Long-term

Ideally I would like to have me own portfolio forever. I do not have any rotation policy in my portfolio. However, being realistic, neither I will always make the right choice nor my companies will not regress to the mean. Hence, my holding period is the period of time while the company in question can generate an excess return for me (I love how Pat Dorsey explains it).

Hence, if I achieve a large return quickly, meaning future returns might be second-rate, then I will seel that position and look for a better place to deploy that capital.

Thinking process foundation

The approach its quite straightforward: looking (and hopefully finding) companies that will compound over my cost of opportunity with low risk.

To do so, I search for companies whose business and structure I can understand. I combine two approaches to achieve it: business owner approach and the customer vision. As a business owner I search for sectors in which I have an edge over the average investor. In that sectors I can understand the market dynamics, trends and risks imposed by innovation and competitors, among others. Educated as a chemical engineer, industries like industrial companies, biotechnology/pharma/medical devices and technology/software. In general I can understand the business models and company’s dynamics in these sectors.

The customer vision refers to my capacity to appreciate the value proposition of the company I invest in, without falling into personal biases. For example, even though I am not a Monster, Novo Nordisk or Amazon Prime customer/patient I see how they impact people around me daily and I can appreciate their value proposition. On the other hand, I had never been able to appreciate Apple’s one, even though I have owned some of their devices, to the extent that its premium was justified.

Once the type of companies I search for have been established, the next question is how do I build my portfolio. I like to have a reasonably concentrated portfolio. Around 15 companies which I can analyze in depth and which progress I can track would be ideal. Increasing the amount of companies will slightly reduce the risk of my portfolio but increase the amount of decisions I have to make and, consequently, the frequency I will make mistakes.

To find companies with the right set of characteristics I demand I rarely ever use screeners. Instead I usually find industries which potentially interest me by observation of my environment, reading and listening to other investors or deriving from sectors which are in the public eye (e.g. Life Science tools companies like Danaher derived from second degree thoughts in the biologics space).

Characteristics of the company

Linked to the previous section, the characteristics I search for in a company can be split into qualitative and fundamental.

Qualitative

1. Companies operating in sectors with secular trends. E.g. cybersecurity or semiconductors.

2. Companies operating in traditional sectors with many players to be consolidated. E.g. food retail or jewellery.

3. Companies with a strong moat.

   For special situations, the thesis should be based in a temporary performance gap or headwind instead of the potential benefits of discovering or unfolding a new technology, winning a litigation or discovering new resources.

4. Companies which are customer focused.

   

   Jeff Bezos’ (Executive Chairman and Founder of Amazon) quote.

Fundamental

1. Moderate and constant top line growth.

   More predictable and sustainable over a longer period of time than companies with explosive growth rates.

2. Good margins. They vary depending on the sector so I search for the companies with the better margins than their competitors.

3. Strong cash conversion.

   Generated earnings need to be translated into cash flows.

4. Strong balance sheets.

   Companies with little debt or at least a manageable amount which could be repaid with the cash generated if required.

5. Management

   Skin in the game and skilled capital allocators proved by their track record.

This would be my core principles and the basis of my investment approach. I think it also makes much more sense to place them in writing, not only for me but also for the readers to understand what you can expect from me in future publications.

Finally, this week in X.com I made a poll about which topic should be the next research write-up. A short thesis of Novo Nordisk has been chosen. Hence I will figure out how to best approach it to get it published before the 1st half of December ends.

Stay tuned for future polls in X at @SiemprePulpo.