Is beating the pros possible? Yes! In this six-part series, Jason Del Vicario, CFA, portfolio manager, and Steven Chen, MBA, analyst, at HillsideWealth | iA Private Wealth Inc. will explain why - and how - a concentrated portfolio of global high-quality stocks gives the long-term investor the best chance to outperform both broadly diversified indexes as well as professional money managers.
As a summary thus far, our first instalment in this series suggested that owning a concentrated portfolio (15-25 positions) of exclusively high-quality companies puts any investor, but especially the interested and dedicated retail investor, in a position to generate superior long-term returns and yes, even beat the pros.
To reiterate what we said in the last article, stock picking is a subtraction process. We believe that enterprising investors would have a great chance of harvesting long-term alpha by rejecting the temptation of betting on most public companies that are speculative in nature, and, instead, concentrating on only a few high-quality ones on an exceedingly selective basis. We define quality as the predictable ability for a business to generate a superior return on capital over time.
A couple of reminders here: first of all, it is “return on capital,” not growth, being the ultimate factor for shareholder return. Think about a purely hypothetical scenario where it takes a capital investment of $100-million for a company earning $5-million a year to generate every incremental annual profit of $1-million (think airlines here). Although a 20% growth rate (i.e., $1-million/$5-million) may look appealing, the rate of return from that growth initiative would be a meager 1% (i.e., $1 million/$100-million), compared to a 2%-3% interest rate offered by some savings accounts these days. Therefore, rational shareholders should require the company to not grow at all and to return that capital of $100-million for them to invest elsewhere. In comparison, companies with strong competitive positions generate returns on capital greater than 15% for decades.
Other keywords above are “predictable,” “superior,” and “over time,” indicating that quality is a scarcity. Furthermore, quality companies trading at a reasonable price are even more difficult to come by.
So how do we find that which is scarce?
One principle can be, of course, that those who turn over the most rocks win the game of investing. Therefore, the larger the target universe (i.e., more rocks to turn over), the better. It is worth mentioning that retail investors have a structural advantage here over pros due to less constraints on market cap and liquidity. We spend most of our time turning over rocks in the developed market, for the sake of sound corporate governance, but are quite industry-agnostic as long as the subject is understandable to us. At the same time, we do see a few areas that may provide quality-focused investors with an above-average hit rate. We list some of them below.
Capital-light Business Model
Capital-light businesses are those requiring very little investment to maintain the current operations and even to grow (think the opposite of airlines). Bioventix is one example. The UK-based antibody company employs a royalty model charging fees for global diagnostic equipment makers like Roche, Siemens, Abbott to use its intellectual properties (i.e., the antibody developed by Bioventix). Essentially, the company does not spend a dime on the manufacturing and distribution of those blood-test machines but can still earn a share of the income wherever and whenever a patient does a blood test that involves a Bioventix antibody. According to our calculation, capital expenditure only represents less than 2% of revenue at Bioventix on average over the last five years.
Similar to the royalty model, franchising is another example but lightens the capital requirement to the extreme. The franchisor provides the rights to use its assets (e.g., brand, technology), know-how and supports (e.g., advertising, supply chain) in exchange for franchise fees, royalties and/or other relevant payments (e.g., supply, lease). What can be better than leveraging others’ capital (for free) to grow your own business? The model has been a proven helping hand for a few restaurant incumbents like McDonald’s and Yum! Brand as well as rising stars such as Domino’s Pizza and Wingstop to generate tremendous wealth for their shareholders.
Management with an Owner Mindset
In our experience, nothing drives long-lasting superior performances better than an owner mindset. Common traits include prioritizing returns, thinking long-term, willingness to take short-term risks, being purpose-led, cost consciousness, customer centricity, discipline, conservatism, and consistent lookout for innovation. However, in reality, one (us included) would find it difficult to distinguish some (if not all) of these without being able to work shoulder-by-shoulder with the executive team. Hence, we tend to direct our primary attention to founder-led companies. Historical data shows that these companies as a group outperform others by a wide margin in terms of total stock returns.
Additionally, management that explicitly talks a lot about return on capital and even sets a target on it often excites us.
For instance, Kakaku.com Inc., the operator of two leading internet platforms in Japan, although no longer seeing its founders around, still maintains a return-focused, disciplined, prudent capital-allocation approach.
Companies like Kakaku.com (the operator of two leading internet platforms in Japan), Credit Acceptance (U.S. subprime auto loan underwriter), and Games Workshop (the UK company behind Warhammer), all no longer have their founders at the helm. But all three companies still maintain a return-focused, disciplined, prudent capital-allocation approach. When asked about its preset ROE target of 40% (a high bar not only in Japan but also compared to companies overseas), the management at Kakaku.com once told us that the idea came from the early generation of the management and has been working so well for everyone that nobody seems interested in changing it. Evidently, the owner mindset is inheritable.
Market Leadership
Competitive position is a good indicator of the width of a company’s economic moat. Generally, we are only interested in companies that are the best in their respective space. Typically, they have a leading market share in a relatively large industry or see no meaningful competitor in a niche domain or an emerging segment. The rationale behind this is straightforward: if the competitive advantage is truly durable, the company should consistently capture new businesses from its peers and/or discourage newcomers. The reverse is also true: no matter how decent the financials look, we tend to stay away from market followers that are unlikely to catch up or companies losing market shares over time, as either the moat is not wide enough or the industry is too competitive (or both).
Our favourite situation, in this regard, is a dominant market position – that is, probably a market share north of 50%. This is rare especially in a world where monopolistic power concerns prevail, but it does exist even in some rapidly expanding domains. For instance, Fever-Tree, a drink-mixer brand from the UK, probably cannot declare itself the absolute No. 1 in the total industry but indeed dominates the premium segment of the industry by owning 50% to nearly 100% shares of that segment in almost every major geography (except Germany). Demand for premium consumer products sees a long-term tailwind globally. This is particularly the case for drink-mixers, which significantly lag behind spirits in terms of premiumization. By taking advantage of its strong competitive position and a favourable secular trend, Fever-Tree has a fairly good chance to maintain its superior return on capital while growing its business.
Disclosure: The authors and funds under their management, as well as their families, own shares in Bioventix, Kakaku.com, Credit Acceptance, Games Workshop, and Fever-Tree.
This information has been prepared by Jason Del Vicario, Portfolio Manager, and Steven Chen, Global Analytics Associate, for iA Private Wealth Inc. Opinions expressed in this article are those of the authors only and do not necessarily reflect those of iA Private Wealth Inc. iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.