We are an active manager with a long-term, private equity approach to investing. Through our proprietary bottom-up research framework, we look to invest in those few high-quality businesses with sustainable competitive advantages and profitable growth when they trade at a discount to our estimate of intrinsic value.

PRICING ANOMALIES

At the heart of active management lies the belief that one can deliver returns in excess of benchmark returns. Over the long term, we believe that markets are efficient. Near term, however, we believe innate behavioral biases, such as herding, overconfidence or loss aversion, influence investment decisions and create asset pricing anomalies. These pricing inefficiencies converge toward intrinsic value over time. Market efficiency is thereby dynamic, existing along a continuum between fully efficient and inefficient pricing.

In our view, two important anomalies can best explain periodic mispricing: short-termism and allocative inefficiency. Short-termism is a behavioral bias inherited from our early human ancestors.

Today, it causes a reflexive response to short-term market variables that, when viewed rationally, have no impact on long-term value. Allocative inefficiency, an example of herding, describes the breakdown in dynamic price discovery that results when widespread investment decision-making is driven by factors other than valuation.

Examples include index or momentum investing and technical trading. Overcoming these natural tendencies is difficult. Consequently, the resultant pricing anomalies persist, creating potential opportunities for active, long-term-oriented, valuation-driven managers like us. Capitalizing on these opportunities requires a disciplined process and a patient temperament.

Our investment philosophy represents our fundamental beliefs regarding the most effective way to generate alpha and leverages our understanding of persistent anomalies that create asset mispricing. These beliefs, or tenets, form the cornerstone of our investment decision-making process and can be linked to performance proof points, demonstrating continuity from belief to process to outcome. Collectively, this integrated system forms our alpha thesis.

We believe that for any alpha thesis to potentially meet its objective, it should be founded on an enduring philosophy and persistent pricing anomalies. We think our alpha thesis is unlikely to be eroded through arbitrage because it is tied to perennial behavioral biases, not specific market conditions.

Because we approach investing as if we are buying into a private business, a long investment horizon is central to our philosophy. In our view, a long investment horizon affords us the opportunity to capture value from secular growth as well as capitalize on the stock market’s shortsightedness through a process called time arbitrage.

The long-term annualized turnover for our Large Cap Growth and All Cap Growth strategies implies average holding periods of seven and six years, respectively, since inception July 1, 2006. ⁱ Measuring name changes only, our turnover is even lower. We launched our Global Growth strategy on January 1, 2016 and our International Growth strategy on January 1, 2020. Our low turnover stands in contrast to a widespread escalation in the average manager’s portfolio turnover. In his book Common Sense on Mutual Funds, John Bogle documented that from the 1940s to the 1960s, annual turnover for the typical general equity fund averaged just 17%. By 1997, average annual turnover had risen to 85%, and by 2009, it had increased to 105%—a staggering six-fold increase. Bogle stated, “The industry has abandoned the wisdom of long-term investing in favor of the folly of short-term speculation.” ⁱⁱ We could not agree more.

Our Quality-Growth-Valuation investment process begins with the art of trying to identify high-quality companies—those with unique, difficult-to-replicate business models and sustainable competitive advantages. A successful business will attract competition and capital, which over time could shrink profit margins and lower returns on invested capital for the business. We evaluate the entire global value chain and profit pool to help discern the companies we believe will be structural winners and losers over the long term. A quality business—one with a wide economic moat—can sustain and even extend its competitive advantages so that its profitable growth opportunities are not eroded by the competition. Quality companies also tend to exhibit sound balance sheets, strong returns on invested capital, healthy cash flow growth and highly capable management teams who can efficiently allocate capital.

A focus on investing in high-quality companies not only helps capture upside potential, but can help manage downside risk as well. This is important given the number of negative return periods the Russell 3000® Index  experienced over a 37-year study period, shown in the table below:

Growth is the next component we consider in our Quality-Growth-Valuation investment process. We are looking not only for above-average growth, but sustainable and profitable growth. Easier said than done, as empirical evidence shows only 10% of companies can sustain above-average growth rates over a four-year period.^x Our systematic approach to measuring a company’s growth prospects begins with quantifying the total size of the market into which they can sell their goods and services as well as their current market share. An evaluation of the profit pool allows us to identify those businesses we believe are best positioned to capture and retain a larger share. We then assess the company’s pricing power, if any, their margin expansion potential, capital requirements and operating leverage.

Our objective is to define the company’s competitive advantage period in order to determine how long into the future we will estimate the key variables for the business. Our proprietary models are built through bottom-up fundamental analysis. It is important to note that we develop our growth estimate is developed independent of company guidance or Street expectations. To assess the sustainability of the company’s growth rate, we evaluate the drivers of that growth. We are looking for long-term secular and structural growth drivers— dynamics that are not likely to change for five years or longer. The transition of consumer shopping from in-store to online—still only at low-teens penetration rates in the global consumer market—is an example of a long-term secular driver of growth. Developing insights about a company’s growth potential is essential to measuring its future cash flows, its profitability and, ultimately, its intrinsic value.

Because we define risk as a permanent loss of capital, we take an absolute-return approach to investing and seek to actively manage our downside risk. More commonly, risk is framed in terms of relative returns and tracking error versus a particular benchmark. While benchmarking investment performance to a specific index began as a tool to help understand and judge portfolio manager performance, this relative-return orientation has morphed into the baseline for acceptable risk and return. Measuring risk, however, must not be confused with managing risk. What’s more, we believe defining risk in relative terms obfuscates the fact that the benchmark itself is a risky asset.

This is particularly true with cap-weighted indices because downside risk increases significantly when the stocks of a particular sector experience a run-up in prices that are above (in the case of a bubble, far above) their fundamental intrinsic value. If portfolio managers tie investment decisions to benchmark holdings and risk factors, they must necessarily take on this additional downside risk. Because our strategy is to invest in a stock only when its market price is at a significant discount to our estimate of a company’s intrinsic value, we actively pursue both greater upside potential and the possibility of lower downside risk.

Diversification is another important tool in managing portfolio risk or volatility. However, we do not think diversification is the simple notion of more is better. Many investors wonder whether a 30-40 stock long portfolio can be sufficiently diversified. Studies dating back to the 1960s have sought to determine how many stocks a portfolio must hold to maximize the benefits of diversification. Results have ranged from 18-30 stocks.^xiii A 2010 study by Citigroup demonstrated that a portfolio of 30 stocks was able to diversify more than 85% of the diversifiable risk. The diversification benefit of adding more stocks to the portfolio declined significantly as the number of stocks increased. For example, adding 70 more stocks to a 30-stock portfolio improved diversification benefits by just 9%.^xiv Legendary growth investor Phil Fisher notes, “Too few people, however, give sufficient thought to the evils of the other extreme (over-diversification). This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them.”^xv

Cognizant of this risk, we instead seek to enhance risk management by diversifying the business drivers to which our holdings are exposed. We identify the primary business driver through our bottom-up valuation analysis for each company as the growth driver that has the largest impact on our estimate of its intrinsic value. Examples include growth in e-commerce, increased consumer spending in emerging markets, the shift to outsourcing and the ageing population. We seek to invest in business drivers that are imperfectly correlated because the positive impact of one may offset the negative impact of another. We believe this fosters more efficient diversification of risk and helps us keep our attention focused on searching for those few businesses that meet our disciplined criteria.

An analysis of portfolio sources of risk across all of our strategies reveals that security selection is our primary source of risk, while the effect of factor risk is minimal. We believe this is an outcome of our disciplined bottom-up stock selection underpinned by adherence to our Quality-Growth-Valuation investment process.

We believe that we cannot truly manage risk at the portfolio level if we do not first manage risk at the individual security level. We take a long-term structural and permanent approach to risk management Therefore, our risk management is an integral part of our investment process, not a separate overlay or optimization process. We agree with Warren Buffett that one of the riskiest things investors can do is to invest in a business they do not thoroughly understand. As a bottom-up fundamental investor, risk management is therefore integrated with our analysis of business models, competitive advantages, operating efficiency, corporate management integrity, profitable growth and valuation. In short, our active risk management process is an integral part of our active investment process.

For any investor, the goal is to identify those portfolio managers who are most likely to deliver superior risk-adjusted returns in the future. In our view, a performance track record cannot readily explain the level of skill employed to achieve the results, or guarantee continued success. We believe a focus on the quality of a manager’s investment philosophy, process and decision-making offers a better method for evaluating the probability of future success. Our alpha thesis encapsulates a deeply held system of persistent beliefs, a rigorous, repeatable investment process and substantive proof points. For alpha generation, the pursuit of greater upside potential and managing absolute levels of risk are inextricable goals. Each tenet of our alpha thesis is designed—individually and collectively—to promote this dual objective for our investors.

This report was originally published in December 2012. We have updated the content as necessary and otherwise believe the information is current and relevant.