Since the beginning of my investing career, I have always believed in only investing in what makes sense [I know, thanks for stating the bleeding obvious Sam, here we were investing in stuff that made no sense at all!!!]. However, as I learned more about the amazing and wide-ranging world of investing, the number of investments that made sense to me dwindled significantly.
The belief of simply investing in what made sense naturally led me to work at ECP because it is an investment firm founded by an engineer centred around a disciplined and rational investment process.
At ECP we believe in simple, rational thought. Since starting at the firm nearly three years ago, I have learned that every decision is made with clear and logical reasoning; and once that rationale is established it is carried out with unwavering discipline with both eyes on the long term.
These are two attributes I admire most about our team’s process, so I thought I would share some of the rationale around our investment decisions that have helped us deliver to our clients +6.1% p.a. alpha in our Ex-50 portfolio and +4.1% p.a. alpha in our All-Cap portfolio over five years. (As at Dec-18).
Our philosophy guides everything we do
We believe that over the long term, companies growing their economic footprint (profitably) are better investment opportunities than those that aren’t.
This leads us to invest in companies that are in the growth phase of their life-cycle, which generate high returns on invested capital and do so organically, without leverage.
These attributes can be quantified using the accounting based metrics, which form the basis of our investment process.
Have a clearly defined process
Stemming from our founders engineering background, ECP’s process has been engineered over decades to codify a set of investment principles.
The first tenant of our philosophy is that we are long term investors. If we are serious about long term investing then there are a couple of key attributes of a company that we must see before we begin our research process.
The following 3 accounting-based metrics are indicators that the companies we invest in are likely to meet our requirements. We use these as the starting point for researching any investment:
1. Sales Growth
Sales growth is essential to growing your economic footprint. You cannot grow in the long term by cutting costs, there is only so much you can cut, and even less that you can cut without hurting your business over the long term.
We only invest in companies that organically grow sales above GDP and can sustainably do so because they have a large, growing market opportunity and a compelling competitive advantage which drives ongoing market share gains.
2. Proven Management + Proven Business Model = ROE above 15%
Our investment philosophy is built on the belief that a stock’s long term return to shareholders is driven by the return on capital of the underlying business. And that long term investors are really backing a management team and a business model.
Management make crucial decisions regarding the company’s strategy and its competitive position in the marketplace that impact a company’s future profits. It is critical that we have confidence in their ability to execute.
A company’s business model is also critical to the magnitude of the returns that it can generate for shareholders, but it can also limit a company’s future strategic direction. Decisions such as what parts of the supply chain to own versus outsource, who to partner with or how to price its services can all impact a company’s long term profitability.
One way to assess the track record of both the company’s business model and its management team is through its long term Return On Equity (ROE). A high ROE can be an outcome of smart decision making with a strong business model and evidence that the company has a Sustainable Competitive Advantage (SCA).
That said, there are also lots of other reasons for a high ROE including write downs, over leverage, restructures and interesting accounting policies which is why we urge rational thought when assessing a company’s financial statements.
3. Resources to execute on its strategy = Interest cover above 3x
As long term investors capital preservation is our number 1 priority. There is nothing that changes a management team’s focus toward the short term quicker than an upcoming debt refinance when market conditions suddenly change.
We need to be comfortable that this will not happen and that the company has a strong enough balance sheet so that it will retain optionality and can easily execute its strategy over the long term.
There are a number of ways to assess a company’s balance sheet and we assess it from a number of different angles. However our initial screens look at the magnitude of the debt and debt serviceability. Specifically, we are looking for an interest cover greater than 3x.
Apply with unwavering discipline
The above 3 key attributes may seem blindingly obvious as hygiene factors before you even begin to research a company, and we do think they are obvious. However year in year out, we continue to see investors make mistakes in all three of these areas.
How often have you seen a share price re-rate because management announce a “transformation project” or “cost-out program” only to have the share price wane in the following few years as the outcomes disappoint on initial expectations. Or a debt fueled “accretive acquisition” that ultimately fails to integrate and generate the exciting synergies touted in the investor presentation.
These sugar hits rarely lead to sustainable earnings growth over a 5 plus year time horizon and are often achieved at the expense of investment in a company’s SCA.
In order to maintain our investment discipline and avoid the inevitable ‘come down’ from the sugar high, our team applies a rigorous research process over the top of the above three attributes.
We focus on industry dynamics, key success factors, competitive positioning, ESG risk factors, sources of Sustainable Competitive Advantage, management and financial due diligence and lots more.
All these assertions are then openly debated between our team with more than 80 years of combined experience before deeming a company investment grade.
We don’t stop there…
Rational thought extends well beyond ECP’s investment process. We believe that we need to continually learn from our mistakes and improve all aspects of our investment decisions if we want to keep delivering strong returns for our clients.
So instead of recognising a mistake we have made and then trying to correct for it in the future, each year, we have a different team member review our process and identify mistakes and areas for improvement. Data is collected and where possible we back test the implications of any changes on the portfolio to prove up the rationale for a tweak to our investment process before it is implemented.
Like everything we do, our decisions must be evidence-based to engineer a better long term outcome for our clients.
It is just that simple.
The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. For further information, visit www.ecpam.com. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial advice. ECP and the analyst own shares in IDP Education. ABN 26 158 827 582, AFSL 421704, CAR 44198.
