Benjamin Graham, believed by many to be the father of value investing, wrote in his book The Intelligent Investor, “Confronted with [the] challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY”.
Simply put, Graham’s margin of safety is the difference between a company’s stock price and its intrinsic value. Contrary to the common view that higher returns can only be achieved by taking greater risks, value investing is based upon the notion that increased returns are associated with a greater “margin of safety”, or lower risk.
A key attribute we look for when investing is companies addressing a large, growing market. Why? Because this is the runway to possible returns. We often talk about investing in compounders, companies we have assessed as having a potentially long-term, identifiable growth rate.
But making that analysis is based on a wider exploration of the target market and also the competitive landscape, and applies to companies of any size. We research the history of the industry vertical and the current market, as well as making thoughtful, educated predictions about where the future is going.
Due diligence has always been a core part of The Pender Investment Process. Undertaking the fundamental analysis of a company from the bottom up ensures that before we invest, we fully understand the potential risks and rewards. It’s clear to see from the hype and headlines that the level of due diligence undertaken can vary widely for different investors, and some will move quicker than us.
However, we pride ourselves on our high level of due diligence in assessing the people, the product, the market and the business economics. We firmly believe that in doing so we acquire the knowledge to mitigate losses on the downside and help drive superior risk-adjusted returns on the upside.
Warren Buffett once said, “You’re looking for three things, generally, in a person. Intelligence, energy, and integrity. And if they don’t have the last one, don’t even bother with the first two”. When you are looking to invest in a small company, often a private company, there is very little to base your assessment on. Track records are often short and financials can be skewed. So, one of the key factors we turn our attention to is the quality of the management team. For small businesses, it really all comes down to the human factor – people, striving towards a common goal. And, as Buffett puts it, there are three attributes that count.
Intelligence – we talk to a whole host of people from past and current employees, to professors and mentors. We analyse past decisions and try to identify the mental models they use to operate. Energy – how did someone get to where they are today? Did they inherit or build from the ground up, how many trials and tribulations did they overcome on the way? A history of hard work can be a predictor of the future. Integrity – what do people value above all else? What they say and how they react during a rough patch can be two different things. Watching how someone navigates choppy waters and, in particular, how they prioritise to overcome obstacles can be a strong indicator of integrity. If we are signing on to a ten-year relationship, then we had better be sure that we have backed a team that can deliver.
Warren Buffett has provided many pearls of wisdom and one of our favourites is the reminder to “be fearful when others are greedy and greedy when others are fearful”. It is a contrarian viewpoint and just makes good sense. So often we see investors caught up in the hype and buying high (along with the crowd) and selling low (out of a fear of further price declines).
Markets move through classic cycles from trough (maximum pessimism) to peak (maximum euphoria) and it takes a recognition of this and discipline to do the opposite of the crowd. When viable industries are simply out of favor, this is fertile ground to begin our research.
From the perspective of companies, it is not uncommon for them to cut costs and turn their attention to balance sheets when times are tough. This increased focus on the things that are necessary to allow them to survive a downturn ultimately puts them in a stronger position when things turn. Which brings us back to “buy low and sell high”.
Bonds are a debt that a company owes to its holders. They are an obligation to repay the debt at the maturity date. As with almost all investments at Pender we “begin with the end in mind”. So before we invest we ask ourselves, “how will the company pay us back?” And even once we have made the investment, that question is never far from our minds.
We look for situations where business valuation exceeds debt. We want to know that, should the company not be in a position to pay us back in cash, that it has assets sufficient that, if liquidated, could cover the debt. The higher the coverage the more likely we will get our money back at maturity.
Our approach to investing involves determining intrinsic value and investing in situations where the market has not yet recognized the value we are seeing through our analysis – when the current price is below our estimate of intrinsic value. The share price moves higher as the market begins to price in the value, generating returns for the holder.
An additional benefit of buying at a discount to value is that as well as locking in potential returns, the lower the purchase price, the higher the buffer against potential risk associated with the investment. Should markets drop, a mispriced security may not have as far to fall. In aiming to protect and grow wealth over the long term, it comes down to holding a security for as long as it takes for the value to be realized and priced in by the market – in equities this may take years.
In the words of Howard Marks: “You can’t predict, you can prepare”. Following the trend might feel like a comfortable thing to do, there is safety in numbers. However, when the cycle ultimately shifts to one of pessimism, share prices will fall. Market timing is unrealistic. The best defense we have against the cycling of the markets is to follow our investment process – to look for undervalued securities, to carry out our due diligence and to purchase those securities that are trading at a discount to their intrinsic value and may well be out of favour.
The securities with the highest risk are, counterintuitively, often those that most market participants are excessively positive about. With enthusiasm comes buying, with buying comes price increases and as share price increases exceed intrinsic value, they become increasingly ripe for a correction. When value metrics become expensive on a relative basis to competitors and the market, we need to consider trimming or selling the holding entirely, especially with close-the-discount ideas. Nothing goes up forever.
At Pender, we consider ourselves owners of a business, not just its stock, which means that when we think about risk we believe that real investment risk is not measured by fluctuations in a stock’s price, but by the probability of a “permanent loss of capital”. We therefore focus on three main factors during our investment analysis process:
Valuation Risk – If an investor over pays for a stock, it doesn’t matter how well the underlying business performs, the returns will likely be mediocre or worse.
Business Risk – The danger of a loss of business quality and earnings power through economic change or deterioration of management.
Balance Sheet Risk – Investors tend to ignore balance sheet and financial risk during stock market booms.
As a Fund Manager with many small cap holdings, liquidity is never far from our minds. We are focused on ensuring we preserve and grow the capital investors have entrusted to us and an acquisition is both a liquidity event and a potential value creation event.
So how do we pin point a take-out candidate from the wide field of publicly traded entrepreneurial prospects? “The truth is we rarely buy expecting a take-out”, says David Barr, President and Portfolio Manager. “However it’s a by-product of our process, our private equity approach to public markets.”
More than stock picking, we fundamentally analyse every aspect of a potential holding, which includes the customer base, the competition, the industry as a whole and more. Our experience has revealed some of things that we believe correlate to identifying potential take-out candidates.
“I’m no genius, but I’m smart in spots, and I stay around those spots.” Tom Watson [IBM founder]
Warren Buffett and Charlie Munger said it best when they recommended that investors stay within their “Circle of Competence”. Your circle of competence is the knowledge base you have developed, over and above the average investor, for example in a certain part of the market or investment type. Having an informational and analytical edge means you are in your comfort zone and unlikely to be put off from investing, even when a sector or situation seems complex to others. The ability to quickly assess the key fundamental driving factors of a given investment opportunity can tip the odds in the favour of the prepared investor, which can result in uncovering unique opportunities and being in a smaller pool of investors, both of which have their own advantages.
As fundamental investors, we seek to obtain more value than we are paying for. To do this, it is helpful to be patient and maintain a long-term viewpoint. Patience is a scare attribute in modern day investing and hence, it is one of the most valuable differentiators. There are two key investing benefits from patience:
1. Patience to wait for the “fat pitch”- Most investment ideas are mediocre, or worse. The reality is that the most compelling opportunities that also fall within your circle of competence don’t come along that often. But when they do, you should be prepared to act with conviction. In the meantime, it’s important to stay patient and disciplined until such attractive opportunities emerge.
2. Patience to hold on to your winners – The first rule of compounding is to never interrupt it unnecessarily. It is important stay invested in “compounders” as long as the underlying business value grows at a satisfactory pace and valuation levels do not climb to extreme levels.