Strategy and Philosophy
An all-equity strategy utilizing Core and Satellite portfolios through stocks and options. Within the Core portfolio, the majority (~80%) of stock investments are concentrated in 15-20 competitively advantaged companies (Big Bets) and the remaining portion is invested in other high-conviction bets (Small Bets).
We selectively maintain cash in the portfolio, where the cash allocation largely depends on current market valuations and the availability of companies at good prices – higher cash allocations when valuations are unreasonably high and vice versa. Given the changing cash allocation, we adopt a Satellite portfolio strategy through Equity Options that seeks to exploit cash as a platform to generate income using cash-secured puts or credit spreads on high-quality companies or indexes at steep discounts to their current market values. This allows us to achieve above-market yields without taking the equity risk exposure. As a result, the proceeds received from this option strategy are evaluated from a capital allocation perspective and deployed in the most profitable way, taking into account the available opportunity set.
In summary, adopting this mix of Core and Satellite portfolio construction strategy allows the portfolio to keep growing in size and creates a cycle of cash generation under any market conditions.
Below is the detailed investment process:
Long Equity Investment Strategy (Core):
Our long strategy is accomplished through two main styles:
Big Bets: these represent high-quality, competitively-advantaged companies with great capital allocators running the businesses.
Small Bets: another term for these is what Warren Buffet calls “Cigar Butts”. These are quantitative plays where the securities are believed to be “too cheap to be true”. Believe it or not, the market misprices assets a lot of times.
In all cases, prospective companies must have solid and quality balance sheets, and that serve as the main form of downside protection.
Within Core, we concentrate our capital in 15-20 Big Bets businesses with the potential to compound shareholder value at above-average rates. We purchase these businesses at what we believe to be a reasonable discount to our assessment of intrinsic value at an appropriate cost of capital, and seek to invest in companies with managers who we believe can allocate capital in ways that benefit long-term shareholders.
Our search process for new investments is largely quantitative and fundamental, hence Quantamental. Within Big Bets, the investment universe consists only of businesses with economic moats — such as high switching costs, network effects, and scale advantages — that insulate high-returning companies from competition. Economic moats are the foundation of our investment process, but moats require reinvestment opportunities to maximize the value of a competitive advantage, and capital allocation links business value and shareholder value. The ideal investment combines all three elements — a moat to isolate the business from competition, reinvestment opportunities to generate value-additive growth, and superior capital allocation to ensure that shareholders enjoy the advantages of increasing business value.
Of course, a great business is not a great investment if its valuation already fully reflects its future potential. Our guiding principles when it comes to valuation are twofold. First, We believe it is better to be approximately right than precisely wrong, and so we work hard to avoid the trap of false precision. Second, we believe that valuation is a double-edged sword — maximizing one’s margin of safety at purchase must be balanced with minimizing the opportunity cost of not owning a business with the potential to compound at high rates for a long period of time.
For investment theses to materialize, one must allow at least five years to gauge performance. To us, anything less than five years is a speculative operation, unless material changes occur to the industry structure, company-specific developments or extreme price run-up that justify closing positions.
Sources of Competitive Advantage:
Intangible Assets
Brands (differentiation)
Patents
Governmental Licenses
Switching Costs (Stickiness and customer lock-in)
Network Effects
Cost Advantages
Cheaper Processes
Better locations
Unique Assets
Greater Scale (High replication costs)
Distribution
Manufacturing
Niche Market
“Low barriers to entry equals high barriers to success”
Pat Dorsey
Types of Moats (from most attractive to least attractive):
CAPITAL-LIGHT COMPOUNDER: A company that is insulated from competition and has the opportunity to grow, but due to very high returns on incremental invested capital does not need to reinvest significant cash to do so. These companies can return cash to shareholders or engage in M&A even while growing.
REINVESTMENT MOAT: A company that is insulated from competition and has the opportunity to reinvest their cash flow into growing the business at attractive incremental rates of return on newly invested capital.
LEGACY MOAT – PLATFORM: A company that is insulated from competition, but without material opportunity to grow through reinvesting cash flow. Chooses to deploy their distributable cash flow in service of acquiring other highly aligned companies with similarly attractive economics.
LEGACY MOAT – CAPITAL RETURN: A company that is insulated from competition, but without material opportunity to grow. Chooses to return distributable cash flow to shareholder via dividends and buybacks.
NO MOAT: Companies that may be well run and sell good products and services, but which do not exhibit characteristics that prevent other companies from competing away above average profits. Most companies fall into this category.
“It can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it. But we are trying to figure out why is that castle still standing? And what’s going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors?”
Warren Buffett
Some of the key points we look at when assessing a business:
Return and Incremental Return on Invested Capital (ROIC and RONIC)
Growth Rates and Retention Ratios
Profitability and Financial Health Ratios
Economic Moats
Capital Allocation
Management Stewardship
Valuation
“One should prefer businesses that have high returns on capital and that require little incremental investment to grow”
Warren Buffett
Options Strategy (Satellite):
As a return enhancer, our Satellite strategy entails writing far Out-The-Money (OTM) cash-secured puts that seeks to maximize returns on idle cash. The range of returns on these strategies are wide and can vary anywhere between 4% to 50%+ per annum, depending on our risk-tolerance and market as well as fundamental factors. Based on the available opportunity set, the proceeds from this strategy are then assessed for re-investment or deployment into the Core portfolio.
Reinforced by Dorsey Asset Management and Saber Capital Management Strategy and Philosophy