We are deeply saddened by the scale of human suffering that has resulted from the Russian-Ukraine geopolitical situation, which was the major cause of recent market volatility. It has reinforced to investors the importance of investing in companies with strong underlying fundamental characteristics – industries with high barriers to entry, switching costs, pricing power, and strong network effects. As a reminder, despite the headlines, the Russian economy is less than 1% of world GDP, and the US S&P500 being forward-looking in nature, will likely be increasingly seen as a safe haven asset in turbulent times.
Portfolio construction is the art of constructing portfolios that represent a handful of measurable investment attributes that have been proven, over time, to be predictive of stock price returns. For example, clients will know that we focus on the quality characteristics of a company, which we define as high current or future expected profitability, and low debt ratios. Quality, when accompanied by attractive valuations, has tended to outperform market expectations over extended timeframes, leading many investment portfolio managers to filter out their universe using past empirical data that attempts to replicate quality. These conventional empirical strategies, however, are mostly backward-looking, while our fundamental strategies tend to employ forward-looking measures of expected success that can result in future business quality. We believe that this strategy is more predictive of future shareholder returns. As we pointed out in a former investment journal installment, it was Wayne Gretzky who is known for saying “I skate to where the puck is going to be, not where it has been.” Similarly, markets are forward-looking discounting mechanisms that will discount the future projected earnings of companies at varying rates of return and time horizons.
There are multiple steps in our investment process in identifying high quality companies. First, we will examine the industry to see that it is a large, growing addressable market in which multiple companies can thrive. Then, we assess the capital allocation practices of the companies to understand how organic growth is being created, and how consistent it is. Many times, these companies may be investing a high proportion of their existing profitability into building a durable business that has long-lived earnings potential. Finally, we assess management to understand the alignment of interests, with a particular eye on companies that are owner-operator led. Over time, the result of consistent, results-driven business decisions will then result in the highly desired attributes that investors pay attention to: Secular earnings, long-lived growth, high returns on invested capital (ROIC), and a track record of deploying capital effectively.
Besides quality, there are other factors too, which when integrated into a portfolio, can have their unique performance impacts. Companies that are attractively priced, or undervalued for prolonged periods of time, may start to outperform once earnings growth starts to surface again. We have seen examples, throughout the pandemic, in consumer discretionary stocks that have regained their footing as their end markets re-open again. As a second example, in a modestly rising interest rate environment, still accompanied by slow growth, investors may value the steadiness of a rising dividend yield, and so dividend growth strategies may be looked upon as a safe haven in times of uncertainty. The semiconductor industry, which sports one of the highest dividend growth rates, is one such example in which we have positioned client portfolios.
Finally, monitoring changes in how factors are being rewarded is also part of our portfolio construction process. Many large cap technology companies with wide, defensive moats, have both an attractive growth profile as well as another element investors look for: Predictability. There is a premium paid for this predictability, much the same way there is a premium paid for low volatility shares with profitable track records and select fixed income instruments.
Understanding our benchmark’s characteristics, the S&P500, allows us to understand which characteristics are being rewarded, and why. For instance, in the information technology sector in the S&P500, the average price to earnings ratio is 30x, but profitability, as measured by return on equity, exceeds 36%. In addition, these are companies that are highly cash rich, with negative debt ratios (indicating the company is in a surplus position). So, this demonstrates that investors are willing to pay a premium for high, sustained profitability and strong balance sheets. Qualitatively speaking, these are business models that have successfully productized their ideas, implemented strategies for growth, now have high degrees of recurring revenue, long timeframes for growth, and favourable capital allocation practices.
Our final point is on volatility. Tracking error is defined as the volatility of the portfolio in relation to the S&P500, its benchmark. This is an important metric to understand, because it measures the variation of a portfolio’s historical returns against the returns of the S&P500. The greater the variation, the more the volatility, and vice versa. Maintaining prudent portfolio management standards, such as position sizing, analyzing volatility trends by name and sector, and maintaining sector weights that reflect our economic outlook are all tools that we employ to manage tracking error and its associated dispersion of returns.
We hope clients have found this piece to be informative. We are happy to receive comments and answer any questions.
Stay safe and warmest regards,
Grace, Sam, Leslie, Jennifer and Kim