Introduction of our investment philosophy – process and positioning
by Fabrizio Pierallini, head investment department
Our investment approach is based on a disciplined and rigorous research-driven process. I have learned, although not always on the easy side, how to navigate through the different market cycles. Our investment process begins with a bottom-up analysis, as I have been doing for several years in the US and nowhere in Europe. Osiris Asset Management is based on the same principles when it comes to investing, i.e. a research-driven process. Let me give you some insights on the kind of variables we focus on in our investment process and on the kind of businesses we aim to own and what the key tenets are:
Business characteristics: Our goal is to have companies that have stood the test of time and have strong and lasting competitive advantages. We look for businesses that serve large addressable markets and benefit from favorable secular trends. We favor business models that have high levels of recurring revenue, generate attractive incremental margins, are cash generators, and are not dependent on third-party financing. We invest exclusively with management teams that we consider exceptional and invest in their businesses to generate long-term profitable growth.
How we generate investment ideas: The process is a negative art, which means that identifying what not to do is as important as what to do. Investment ideas are like an assembly line that brings together a large number of factors and then reverses them. We believe that great investment ideas need a lot of preparation, diligence, and patience. Investment can also come from unexpected places. We use a combination of screens, industry seminars interviews of management, corporate visits, and research trips. Observing it comes by using different ideas, and great ideas cannot be produced by demand. The key is understanding different business models, why some companies are better than others. That leads also to read a lot of annual reports, listen to podcasts, it is a process to be curious and spend a lot of time reading topics that might not be imminent for the portfolio today. The goal is to get to an investable universe, or call it a circle of competence that acts as a watch list of companies that we know well and wait for the market to give you the right price – it needs a lot of patience. For long-term investors, the best investments come from the best companies.
What Business Profiles: Therefore, companies should be expected to have asset-light qualities and therefore perform better during periods of normal inflation. They should display high ROI or ROC, strong balance sheets and they should be re-deploying their cash flows back into these core activities, to support the growth as opposed to favoring high dividend payments and/or share buybacks. By looking at ROC, we tend to discover businesses that consistently portray high-profit margins and tend to have a limited need for additional investment, and are consistently generating high levels of cash-flow. Such financial characteristics in turn reflect business fundamentals, including the level of competition in an industry, the relative concentration of suppliers and customers, and the degree of regulation facing an industry. In situations where a company continues to re-deploy capital at a high rate of return, the value of the business is bound to grow over time. Financial strength is probably the easiest of the four characteristics to recognize. We like companies with little to no debt, recognizing that there is very little margin for error when investing in heavily indebted companies. When a leveraged business is doing well and profits are growing, returns to equity holders can be enormous, as every incremental dollar of profit accrues to the equity owners.
What Businesses We Avoid: Typically, commodity-based industries, in which companies are price takers, as well as other mature sectors, such as banks, general engineering industries, automobile stocks, and those businesses in a similar line. We also tend to avoid asset-intensive industries such as those in the utilities and telecommunications sectors, as well as overly diversified business models that do not excel in any type of leadership or have little or no pricing power. And last but not least, those unpleasant industries that are considered harmful to society.
What Businesses We Favour: There are two types of companies, monopolies, and non-monopolies. One makes money the other one never does. It’s an interesting thought, today on Capitol Hill the top technology companies are saying they are not monopolies, it is not exactly black and white. Monopolies are companies that can make money, some companies are not monopolies and produce profits. What are some of the key factors? There are some common denominators – they have to produce a high return on capital that investors funded on it. So that should be the result of great companies. But adaptability to change is key – change is a constant now – Buffet likes to say he invest in companies that are resistant to change – we believe that companies that are capable to be adaptable to change are key – if you not willing to embrace change – the industry might force you. So management is important – but also human capital is great. The company needs to be able to retain and attract great people.
EXAMPLE OF ONE OF OUR INVESTMENTS:
FACEBOOK is an example of being very adaptable to change. And it is a quality of change. FB IPO during existential crises, so instead of continuing to milk advertising money, Zuckerberg bought Instagram, which is a mobile application. He reassigned engineers and discovered how to make an ad without making it feel like an ad on your iPhone. They also made a change when they realized what Snapchat was doing, i.e. handling the messages. They wanted to buy them but were not successful. So they created their own. In the end, Instagram-Stories created more revenue from that. Now they try to adapt again to the editing process after the arrival of TikTok. And now Zuckerberg is doing something similar to TikTok, calling it Instagram-Reels. So it’s a flexible culture. It’s another example of an attribute for good management along with its high growth margins. In general, we like companies with high growth margins. FB for example doesn’t have to spend money to create content because the users are creating their content. In addition, FB does not need as many sales staff as traditional advertising agencies because most of it is automated. FB has 80% growth margins, Snap has 40% growth margins. These are big differences, which leaves a lot of money to pay their engineers for research and development, sales and marketing and still leaves a lot of money for the shareholders. AMAZONAS: Another thing is to look at economies of scale: many large companies exhibit these characteristics. Let’s look at Amazon. They have developed the concept of warehouse infrastructure in the early days. So they sold the space to third parties. Every increase in revenue was pure profit. They built the infrastructure initially, which was expensive to build and maintain. Every new dollar is actually Amazon and others in the company, in theory, have fixed costs and very high margins on a certain amount of revenue on that fixed-cost basis, but in reality, what they end up doing is reinvesting the high-margin dollar back into the business. That does two things: it adds more fixed costs to the initial base, which delays the possibility of reaching the high margins, but it also makes it harder for competitors to attack your business because now the fixed costs to compete are even higher, which helps to widen your gap and you get an above-average return on investment. All are great franchises with unique offerings in growing markets with high-quality management teams. We entered into each of these investments and maintained them while continuing to build the capital over time.
What Do Business Fundamentals Tell Us: Very often an industry analysis is done on a stock by stock level. It gives us a good idea of the level of competition in an industry, the relative concentration of suppliers and customers, and the degree of regulation an industry faces. In situations where a company continues to relocate capital with a high rate of return, the value of the business is bound to grow over time. Financial strength is probably the easiest to recognize of the four characteristics. We like companies with little or no debt that recognize that there is very little room for error when investing in highly indebted companies.
Why We Avoid Highly Leveraged Businesses: When a leveraged business is doing well and profits are growing, returns to equity holders can be enormous, as every incremental dollar of profit accrues to the equity owners. But of course, the opposite is also true: When a leveraged business shrinks, all of the assessment of value is of course a judgment—and therefore subjective. Overall, our stock selection process is highly defined and we tend to own businesses that are of the highest quality, but are suffering strain for some reason: they might have been hit by a cyclical downturn, their management might have misunderstood competition short-term, or the capital structure of the company was affected by a long-lasting recession.
On Market Timing And The Power Of Compounding: Since we cannot predict when economic and market cycles start or end, there is no good time to time the market. Over the past four market cycles, missing the best five days would have resulted in a 36.7% lower value of a hypothetical $10,000 investment, and missing the best 10 days would have resulted in a 53.6% lower value. As big down days are often closely followed by big up days, those who panic and sell on the down days are likely to miss out on the ensuing up days.
Inflation and the Power of Compounding: The purchasing power of the dollar has fallen about 50% every 17 years over the past 50 years. While inflation causes currencies to lose value over time, it has a positive impact on tangible assets, businesses, and economic growth. This means stocks are the best hedge against the devaluation of your money. While the simple answer to combat inflation is to invest your money over the long term, the concept of compounding tells us why. When your savings earn returns (e.g., bank interest, dividends), compounding allows these returns to earn even more returns. Over time, this effect snowballs, and earnings grow at an increasingly fast rate. In year one the amount you earn on your investments will not be a lot. However, in year 10 or 20 you will not believe the impact of the “power of compounding.”
Conclusion: We constantly work with our team of analysts to research and analyze the long-term growth prospects of companies. We spend as much time researching positions, as we do consider acquisitions, as we have for those we have owned for decades. When we determine that the investment’s growth prospects are deteriorating, we move to sell the shares and reinvest in more compelling opportunities. We reached this conclusion in various positions and acted accordingly over the past months and quarters. We also seek to evaluate risk and return profiles on a relative basis and constantly strive to allocate our capital to its greatest and best use. We look forward to discussing in detail some of our working assumptions and will contact you later this week or if you prefer let us know a specific day and time when we may have another conference call.