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 long-term focused investment philosophy is one of our core competitive advantages. It is the way we identify and exploit mispricings in the market that, in turn, allow us to generate outperformance for our clients.
We find it useful to define our philosophy by separating it into two components: the first is a belief about why stocks are mispriced; followed by the way we take advantage of these mispricings.
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. It has been our experience – evident across historical cycles - that 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, or 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 fair or 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 indexes the individual stock moves can be far greater.
- 2) Market participants also fail to properly appreciate the compounding power of high return on invested capital (ROIC) 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 ROIC for Business A is 10% but it is able to earn a ROIC of 20%. This means that every dollar re-invested in the business is effectively “worth” 2.6 dollars because it generates a multiple of the return we require*.
While this is a very attractive attribute, it is even more attractive if Business A has a long runway for growth due to the immense power of compounding of returns. 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.
Those companies that can generate high returns on incremental invested capital over the long term offer further opportunities for an investor with the right time frame.
We exploit the above two examples of mispricing through the execution of an investment process that prices shares independently of market sentiment, using long term, through-the-cycle measures to value businesses.
* As determined by the following formula: (Roe – g)/(Ke –g).
Our Investment Approach
All our portfolios are constructed using a single fundamental, long-term, valuation driven investment process. It is our experience that by 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 repeatable, 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 they are near this fair value.
- Concentrated portfolios
We run concentrated portfolios and emphasis is placed on the stocks in the portfolio. As bottom up stock pickers, we do not need to invest in, or cover in great detail, all listed stocks (“the market”). Instead, we can focus entirely on finding the most compelling individual opportunities on offer.
- 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.
- Risk management
We define risk as the permanent loss of capital and not deviation from the benchmark. Risks 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 our primary risk mitigant.
- 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.