Investment Philosophy
Great companies with long growth runways & situations worth relaxing that rule
The aim of this post is to share my investment philosophy. I consider myself a modern value investor. Traditional value investing is often understood as buying a stock that is trading “cheap” relative to its earnings, its book value, or its net cash on the balance sheet. While such situations can lead to attractive investment returns, the competitiveness of the stock market typically ensures that such companies are cheap for a reason and thus do not provide strong investment returns on a multi-year period.
I seek to invest in great companies with long growth runways trading at reasonable prices. A great company to me is one that is providing a standout customer value proposition to its customers - for example, products or services that are either unique, or systematically better and / or cheaper than what the competition has to offer. What is important to me is that the company’s advantaged value proposition is sustainable and ideally only gets stronger over time.
I am seeking for companies with long growth runways, because topline revenue growth is often a major driver of stock returns in the long run. A company can have great margins, but if the product is already ubiquitous, such as Coca Cola or McDonalds, future returns that the stock can provide to its investors are limited. In contrast, a great product or service that has only captured 1% of its total addressable market, has plenty of growth runway to 10x or 20x revenues. Margins today are often of limited importance if the business can operate on a 10x larger scale in 10 years. Moreover, a clearly defined growth runway often ensures that the company is laser-focused in its capital allocation by growing the core business, instead of destroying shareholder value in M&A without real synergies, or by investing in pet projects.
I do not require all of my companies to be GAAP-profitable from day one. If the business model possesses the right flywheels, the business will scale into profitability over time. I focus on projected profitability at scale. No doubt, profitability from day one is often an advantage, as it reduces a strongly growing company’s dependency on external funding in the capital markets. However, if a service can be offered profitably from day one, it will often also be relatively easy to copy by competitors, hence eroding margins over time.
What I do require is that I can reasonably expect my companies to be profitable “at scale.” This can be in 5 years or in 10 years. In this sense my investment style is overlapping with traditional value investing - I aim to buy companies on the cheap, though not with respect to today’s earnings or cash flows, but with respect to the company’s cash flows in 10 years.
“Prediction is very difficult, especially if it's about the future!”
- Niels Bohr, Nobel laureate in Physics
I admit that it is much more straightforward to model out the future cash flows of a company that is already profitable. Margins are already in place and not something that may only arise at scale. In this sense, the number of variables and the uncertainty of the prediction increases.
To compensate for this disadvantage, I must be all the more certain about the scalability and advantages of the business model. At the same time, I consider this weakness of the “modern value investing” approach also its major strength: The longer the investment horizon, the less competitive the financial market, thus allowing for potential superior investment performance.
On a daily basis, individual investors have zero chance to beat algorithm-driven quant funds. On a quarterly basis, there will always be institutional investors with better access to alternative data and consensus estimates to “play” earnings surprises. An investment horizon of one or two years is already relatively long in todays market. As the actual investment horizon (relevant for investment decisions today) expands to 3-5 years, the number of competitors gets smaller, especially because most investors nowadays go the passive way via index-funds or ETFs. As a result, I am convinced that only a minority of investors put in the analytical work to think about a businesses’ future in 5-10 years, while also being sufficiently proficient in financial modeling. I aim to exploit this gap with my modern value investing style.
I do not rule out investing in more traditional value stocks, or companies are already profitable. However, also in those cases I require substantial long term expected returns. In general, I aim to achieve a CAGR of at least 15% from my investments. This implies a doubling every 5 years, or a 4x on a 10-year basis.
For companies that are not yet profitable, I require expected returns that are substantially higher than 15% per year, e.g. at least 20% p.a. In a sense, the difference can be seen as a “margin of error”, i.e. even if the company substantially underperforms my expectations, it may still achieve a CAGR of 15%, or at least matching typical equity market returns of 5 to 10% p.a. For companies that are already profitable, such as Meta Platforms, or Amazon, an expected return of 15% can be high enough.
Occasionally, I will relax the condition to invest in a “great” company in the sense of a uniquely advantaged business in the long run. For example, during the Covid-19 stock market crash of spring 2020, I invested in REITs such as Ventas Inc. or Simon property, when they were trading of discounts to NAV far higher than 50% and implied long term dividend yields of 15% to 20% or more. Interestingly, these companies had virtually no bankruptcy risk, due to their low financial leverage. An irresistible investment opportunity that played out to a doubling of the investment within months.
In general, my investment style is rather focused. Typically, the number of positions in my portfolio ranges between 7 to 15, whereby I consider 10 positions optimal. First of all, there are only few truly great investments available trading at reasonable prices. Secondly, this level of concentration allows me to track my holdings much closer than if I would have to split my attention among 30 different companies. I also see little benefit investing in my 28th best investment idea, as my number 1 will offer much more compelling risk and return.
I aim to achieve fundamental diversification in the sense that the long term success (or failure) of my holdings is uncorrelated. I also try to diversify by maturity of the companies I hold. For example, Meta or Facebook are already profitable, mature businesses, thus independent on funding their growth strategies by raising capital in the equity or debt markets. Moreover, I also diversify internationally, which is why I benchmark my portfolio performance against the MSCI World.