By Sophia Li, Portfolio Manager, FSSA Investment Managers
We have found that one of the biggest obsessions among market participants is “price”. We are often asked about the relative valuations of our company holdings – far more so than the quality of management, the business, corporate innovation, or other fundamental factors.
However, we believe that discussing the quality of the underlying business deserves far more of our time and effort than optical valuations. We believe one cannot possibly get a handle on the various assumptions needed to value a company appropriately without understanding the business in depth.
At FSSA, we seek to buy companies with certain characteristics that indicate a superior franchise, such as a dominant market share in niche industries, strong pricing power, continual innovation (either in terms of product or business model) and an asset-light business model.
Additionally, we look for businesses with high recurring revenue (implying high customer satisfaction and a low churn rate), the rare ability to create new avenues of growth (often making them seem undervalued based on the available information), and a cash-rich balance sheet. Most importantly, the companies we like to own have a strong corporate culture and team of people – which, in our experience is the ultimate source of lasting competitive advantages.
These companies tend to exhibit high returns on invested capital (ROIC), which to us is a good indicator of quality. Many investors prefer to assess companies based on the near-term earnings per share (EPS) growth vs. the 12-month forward price-to-earnings ratio (PER) instead. However, in our view, both EPS growth and the PER carry serious inherent flaws.
First and foremost, they do not reflect the ROIC or quality of earnings. Not all earnings should be judged similarly – earnings that are mostly delivered in cash and from the sources mentioned above are more sustainable compared to those earned in a cyclical recovery, or from reflationary trends, leverage and share buybacks, or those that require a greater amount of capital.
Moreover, short-term PER cannot capture a company’s resilience during periods of turmoil (like in 2020), nor the visibility, magnitude and duration of its future growth, or its ability to defend against disruptive innovation – which, if not managed well could lead to long-term value destruction.
The second important factor that we look at, after ROIC, is sustainability of growth. If a company can demonstrate a track record of creating new avenues of growth (by adding products and services to its existing portfolio) without compromising their normalised returns, they are usually proven to be outstanding investments over time.
On a personal note, having spent seven years studying statistics in college and graduate school, I have been tempted from time to time to lean towards mean reversion theory, or the law of large numbers. These theories suggest that good companies attract competition, which should eventually reduce their returns to the average. Or, that relative near-term valuations (such as the 12-month PER) should revert to the long-term average over time. In other words, poor quality companies often have the chance to rerate, and vice versa.
Notwithstanding the above, our investment strategy is to look for and invest in a few companies that can diverge from the mean for as long as possible. The ability to identify such companies – and refrain from the temptation to follow “conventional wisdom” – is perhaps our biggest value-add to our clients.
As stewards of our clients’ capital, we believe quality should always outweigh price. After we have purchased a company’s stock, we consider ourselves as part owners of a business, rather than just a piece of paper. We hope that we will never need to sell, and that our investee companies will grow sustainably and over a long period.
Source: Company data retrieved from company annual reports or other such investor reports. As at 31 December 2020 or otherwise noted.
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Sophia Li, Portfolio Manager, joined FSSA Investment Managers as a graduate in 2009 and has developed an extensive coverage of companies in North Asia. She is the lead manager of the FSSA Japan Equity fund and FSSA Asia Pacific All Cap fund.
This article was adapted from 2020-03 FSSA Japan Equities Client Letter (part 4 of 4).