🔬 Long Equity Methodology 🔭

🧪 The aim of this guide is to set out the investment strategy I use in picking stocks and managing my portfolio.

🧬 It's important to note up top that this methodology is constantly under review. Investing frequently provides opportunities to learn, both from successes and mistakes. It's therefore important to refine our investment process accordingly, as and when we learn these lessons.

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All-weather outperformance?

The Long Equity investment strategy is a combination of quality investing and growth investing. This means only investing in quality companies that are growining and only investing in growing companies that have a quality business.

Quality investing, as a strategy, has a strong track record of outperformance. Since 1994, the MSCI Quality Index has returned 12.01% compared to the MSCI Index returning 8.52%.

However, this outperformance isn't all-weather outperformance. Outperformance by the index has only been in 11 of the last 15 years - meaning there were 4 years when the quality index underperformed.

While the Long Equity investment strategy seeks to outperform over the medium to long-term, it's important to highlight right from the beginning that there will be years when this strategy doesn't outperform. A long-term time horizon is imperative.

The investable universe

Most companies aren't of interest to us. Those that are have revenues that are:

Resilient and recurring,
Diversified, and
Growing.

Resilient and recurring

The strategy doesn't invest in companies selling anything discretionary, because as soon as an economic downturn arrives, revenues can plummet. This means no automotive companies, no airlines and no luxury stocks. It also means avoiding exposure to companies typically impacted by downturns, such as banks and energy companies. We want companies that are resilient to business cycles, commodity cycles, inflationary pressures and interest rates.

The strategy also avoids investing in companies that sell directly to consumers. We prefer the deep pockets and long time horizons of corporate clients.

💡 We look for companies selling essential, mission-critical products and services to corporate clients - as they are often underpinned by contracts that are unlikely to be cut during a downturn.

Diversified

We want both our portfolio and the companies we invest in to be diversified. This means ensuring the companies derive their revenues globally (i.e. they aren't overly exposed to one country or continent) and are diversified in the products and services they sell.

💡 We look for companies selling a diversified portfolio of products and services to customers worldwide.

Growing

We want companies that not only have revenues that are resilient, recurring and diversified. They must also be growing.

Companies only have two options if they want to grow their revenue:

sell more or raise prices.

💡 We look for companies with a large total addressable market so there's opportunities to sell more.

💡 We look for companies with pricing power so they can raise prices above the rate of inflation.

💡 We look for companies with operating efficiency so that as their revenues go up, their operating costs stay steady or even go down. This means that revenue growth is met with profit margins going up and expense margins coming down.

Pricing power

Most companies can't raise their prices without seeing some form of reaction from their customers.

Companies benefit from pricing power when:

There's no alternative. Companies operating as a monopoly or duopoly benefit from either a barrier to entry that prevents newcomers to the market or a barrier to scale that prevents newcomers growing and taking market share. When companies without competitors raise prices, their customers are forced to stay as there are no alternatives to choose from.
There's no better alternative. Companies can differentiate themselves from competition by offering a better product. The ability to compete on quality is called a quality advantage and requires continuous innovation, the development of unique features and strong brand reputation. When companies with a quality advantage raise prices, their customers are forced to stay as there are no alternatives of that same quality for customers to choose from.
There's no cheaper alternative. Companies can differentiate themselves from competition by offering a cheaper product. The ability to compete on cost is called a cost advantage and requires supply chain control, efficient production processes and economies of scale. When companies with a cost advantage raise prices, assuming they are still the cheapest option, there's no need for their customers to look for an alternative as there’s not a cheaper alternative.
There's no quick and easy way to change providers. Companies can differentiate themselves from competition by becoming embedded in their customer's operations. When changing providers isn't quick, easy and risk-free, it is called a switching cost. The presence of a switching cost can lead to very predictable and recurring revenues, as customers are less likely to move to a competitor due to the time, cost, effort or risk required to make the change. When companies with switching costs raise prices, customers will be hesitant to look for an alternative, given the time, cost, effort and risk involved.

💡 We look for companies that have strong pricing power from a combination of barriers to entry/scale, quality advantage, cost advantage and switching cost.

Our two most important numbers

We only invest in companies that have:

A high return on capital, and
A high free cash flow per share growth.

A company with a return on capital of 20% should, theoretically, grow at 20%. This isn't always the case, as many companies don't have the growth opportunities that would enable them to reinvest their profits as high returns. So instead they return their excess capital to investors in the form of a dividend or stock buyback.

💡 We only invest in companies that can not only obtain high returns on capital, but can also convert those returns into a high free cash flow per share growth rate.

💡 We look for companies that are prudently executing a buyback policy, so that the reduction in share count provides a further boost to free cash flow growth. When the number of a company's shares decreases, your stake in the ownership of the company increases.

Affordable debt

We only invest in companies that have affordable debt.

While it's important to be mindful of how much debt a company has on its balance sheet, it's more important to assess whether the company can actually afford its debt.

💡 We consider the cost of a company's interest expense in relation to its operating profit, to ensure that any debt on the balance sheet is affordable.

Valuation

Having identified the companies we're interested in we then need to value them.

We prioritise quality over value, so we will never own something low quality just because it appears to be cheap. We fully anticipate quality companies to be expensive compared to low quality companies.

We are also mindful that there are only two dynamics impacting share price:

Growth - specifically free cash flow per share growth, and
Valuation - specifically free cash flow yield.

Share prices move in response to company's growing and market's changing their mind on valuation.

A high valuation means the market is pricing in high growth, a low valuation means the market is pricing in low growth or negative growth.

We can't predict the market, but we can heavily research the company's we invest in to determine whether growth is likely to continue.

For that reason, we place more weight on a company's growth rate than its FCF yield. If a company has a low FCF yield, but a high FCF per share growth rate, then it might still be good value.

Portfolio management

In managing the portfolio, we attempt to do the following:

✅ Only own the world's finest companies. We achieve this by rank-ordering the companies in our investable universe using multiple quality growth metrics and only investing in those that rise to the top. We won't be able to own every good company, but we can ensure that we only own the highest quality companies.

✅ Target 12-14 stocks. There aren't many companies of the level of quality we look for. Their diverse revenues and strong pricing power should mean we can be content running a concentrated portfolio.

✅ Minimise trading activity. We target no more than 3 new positions in any 12 month time frame, all while keeping the portfolio to 12-14 stocks. While this is a target, the priority is only owning the highest quality growth stocks, not having the lowest turnover. This means we won’t hesitate to sell if the quality of one of our holdings deteriorates, or to buy if we think a company’s quality and growth justify it having a position in our portfolio.

☣️ Risk management. Short-term market volatility is inherent to equities. We think the risk inherent to equities is best controlled through the selection of high quality stocks. This means avoiding companies susceptible to competitive threats, macroeconomic events and political and regulatory risk, and avoiding those lacking a track record, going though a restructuring and possessing weak balance sheets.

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Disclaimer

The content published here is provided for information purposes only. It does not constitute any form of professional advice. It is not to be understood as an invitation or recommendation to buy or sell any of the securities mentioned. The presentation and commentary of investment strategies is not to be understood as an invitation or recommendation to replicate them. Investments in securities may involve significant market price volatility. The value of investments may go up as well as down. Past performance is not a guide to future performance. Before any investment decision is taken, if necessary, consult with a professional advisor.