In the long term, valuation is almost all that matters. Only by adhering to a disciplined process that provides a valuation anchor can one take advantage of the swings that the market can exhibit.
Our investment philosophy is one of our core competitive advantages. It is the way we identify and exploit mispricing in the market that, in turn, allow us to generate outperformance for our clients.
Why does the stock market exhibit mispricing?
- 1) Prices change much faster than the pace at which businesses fundamentally change
We believe the pricing mechanism of the stock market is dominated by short-term thinking and driven by the emotional responses to fear and greed. Evident across historical cycles, the impulse to sell or the expectation that stocks could rise further, often cloud the judgement of the vast majority of market participants.
While fear and greed are the main drivers of volatile stock prices in the short term, stocks also exhibit mispricing when they are misunderstood by the market, when they reflect unwarranted optimism or pessimism on their prospects, or when investments temporarily depress profits.
Because of this short-termism, the price of stocks can differ dramatically from their intrinsic value. The chart below tells this picture best: despite the fact that the US market has compounded at 6.4% for over a century, the experienced annual return over a single year as well as rolling five-year periods has ranged widely. And these large moves are for the market index as a whole; within these indices the individual stock moves can be far greater.
- 2) Market participants fail to properly appreciate the compounding power of high return on invested capital businesses with a long runway for growth
The value of a business that can earn a greater return than its cost of capital, and that has a long runway for growth, should not be under-estimated.
Let’s illustrate this by way of an example: Let’s assume that our required return on invested capital for a mature business is 10%, but the business is able to earn a return of 20%. This means that every dollar re-invested in the business is effectively “worth” 2 dollars because it would take twice as many dollars to generate the same return if we invested in another business whose returns merely matched our cost of capital. While this is a very attractive attribute, it is even more attractive if the business has a long runway for growth because it can keep doing this for longer.
In practice: If one takes Unilever as an example of such a business, one could have paid 48 times earnings for it in 1995 and still generate a return that matched the market return. This makes the 17X multiple that Unilever traded at in 1995, which was considered a very high multiple at the time, appear more modest.
Our Investment Approach
All our portfolios are constructed using a single fundamental, long-term, valuation driven investment process. In following such an approach, we are able to build a diversified portfolio of undervalued assets that provides protection to investors against the risk of loss of capital.
The key aspects of this approach are the following:
- Quality orientation
We are typically interested in businesses that compound returns over long periods of time; generate high levels of free cash flow; have strong balance sheets and demonstrate considerable potential for growth. We value earnings streams, and focus on the source and predictability of these earnings streams.
- Valuation driven
We conduct a proprietary, bottom-up valuation process based on long-term fundamentals, and a long-term time horizon, to derive a fair value for each company that is owned. Stocks are bought when trading at a significant discount to the assessed intrinsic value, and sold when their price approaches this fair value.
- Research intensive
The research process involves an in-depth understanding of the company, its history, its peers, its people, its competitive advantage and its culture. All Titan analysts are generalists, able to price profit across sectors, interrogate assumptions and cross examine investment cases. Team debate and contrarian views are actively encouraged.
- Concentrated portfolios
We run concentrated portfolios and primary emphasis is placed on the stocks in the portfolio rather than being concerned with stocks that we don’t own. We believe in doing one thing and doing it well. As bottom up stock pickers, we do not need to invest in, or cover in great detail, all listed stocks. Instead, we can focus entirely on finding the most compelling individual opportunities on offer.
- Risk management
We define risk as the permanent loss of capital and not deviation from the benchmark. Risk management occurs throughout the investment process, from screening through to the stock’s final selection into the portfolio. Adherence to a margin of safety is the primary method by which we mitigate risk.
- Robust portfolio construction
Our portfolio construction process takes into account stock-specific risks, including business model risk, geographic risk, currency risk, growth risk, environmental, social and governance risks and liquidity levels. Portfolios are constructed to be robust against second order effects and individual investment cases are constantly assessed for the impact of market and information change.