Anthony Cross

Our key investment mantras

Anthony Cross

Along with the other members of the Economic Advantage team, I have been managing money under our investment process for more than 20 years. Over this time, we have developed a number of straight-forward rules and beliefs of investing:

 

  • Make clinical not emotional investment decisions.

 

Stock market investing involves an intellectual battle against the market’s perceived mispricing. The buying decision is often rushed and there can be an impatience surrounding the execution of the trade. When selling, however, the emotion is frequently reversed, particularly if the investment has gone sour. No one likes to crystallise a loss and selling will underline that an intellectual mistake has been made. Denial is frequently the default response leading many investors to continue holding the stock.

 

One of the benefits of having a clear set of investment rules is that it helps force us to make clinical rather than emotional judgements about our investments. This applies to the sell discipline as much as it does our initial investment. So, when a company we are invested in encounters difficulties, we need to judge whether it is suffering from a general industry downturn or whether we should be questioning its long-term possession of competitive advantage. If there is evidence that its competitive advantage is undermined, we will sell.

 

  • Successfully predicting macroeconomic events is exceptionally difficult.

 

We adhere to an investment process that does not involve the prediction of macroeconomic or political outcomes. Exogenous economic shocks are unavoidable and unpredictable, and we believe it is better to concentrate on the selection of companies capable of outperforming over the cycle.

 

The Covid-19 pandemic has really illustrated that some events with huge economic significance can’t be predicted or pre-empted by investors. During this crisis, as in all others, we’ve felt it is important to focus on a company’s ability to trade through a downturn and its potential to emerge on the other side in a position to take advantage of any subsequent upturn. We believe that our businesses, with their strong barriers to competition, attractive market positions and history of high returns, are in a good position to navigate this difficult time.

  • Pricing power helps insulate against such exogenous shocks.

 

Another way of thinking about barriers to competition is in the form of pricing power: the ability to maintain prices and profit margins in a crowded and competitive marketplace. This is an attribute that should be particularly highly valued by investors during periods of economic uncertainty, when consumer confidence and spending may suffer. One of the clearest and simplest ways a company can possess substantial pricing power is through the value of a brand. In simple terms, a company can maintain prices protect profit margins in the face of competition or cost inflation. In more jargonistic terms, we would say that the company’s demand is relatively price inelastic.

 

  • Don’t rely too much on one-dimensional valuation metrics.

 

The simplicity of some of the most commonly quoted valuation tools is the reason behind both their power and their limitations. Let’s take the price/earnings (p/e) ratio as an example. While easy to calculate and very intuitive, this measure’s most obvious limitation is that it is only as good as the ‘e’ – the earnings estimate used. Earnings are hard to forecast. Because we look for companies whose barriers to competition can allow strong earnings to be sustained for longer than is expected, actual earnings often transpire to be higher than the forecasts used in p/e ratios. This means a company’s shares may be less expensive than a p/e ratio suggests. Instead, make full use of your valuation toolkit, exploiting the strengths and recognising the weaknesses.

 

  • Heed Warren Buffet’s advice.

 

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. In other words, it is better to buy a company with characteristics of high quality – such as good cash flow returns on capital invested – than one that looks attractive on a simple valuation metric.

 

The in-depth examination of valuation metrics is very much at the back end of our investment process, subordinated to the identification of the key business characteristics that we look for in a company. We believe that some companies possess intangible assets which act as barriers to competition. This should allow them to sustain earnings growth, which will serve to erode ‘expensiveness’ and generate good long-term share price returns.

 

  • Don’t set share price targets.

 

The stock market is littered with examples of expensive looking businesses that have gone on to deliver further significant share price gains. Instead, our aim is to buy high-quality companies with defendable barriers to competition. We then watch them very carefully to make sure the barriers remain intact and the financial performance is as expected.

 

  • Don’t worry too much about benchmark constitution.

 

The Economic Advantage characteristics that our process seeks to identify in companies are more commonly found in certain sectors of the stock market than others. If a company or whole sector fails to have the intangible assets we look for, we are happy not to own it.

 

  • Look for company managers who have ‘skin in the game’.

 

The ‘principal-agent problem’ is a problem of moral hazard affecting any situation where a principal employs an agent to take actions on his or her behalf. When applied to stock market investing, shareholders in a company are the principal while the company management is the agent. Shareholders want management to make decisions that are in the best interests of the business and owners, but face the risk that managers will instead be guided by self-interest. One of the best ways of reducing this problem is to look for incentive alignment through managers who are also large shareholders. With large companies this can be difficult, given the sums of money a manager would need to possess. But with small companies, one of our rules is to look for managers who own at least 3% of the company’s shares – giving them a significant economic interest in the business.

 

  • Follow Dr Ramo’s approach to ‘Winning by not losing’.

 

In its original context, Dr Simon Ramo suggested that – aside from matches between elite players – tennis games tended to be decided not by who won the most points, but by who lost the least. While the professional player is capable of making few mistakes and playing ‘winners’ which his opponent is unable to respond to, the amateur rally most often ends in a mistake, with unforced errors far outnumbering ‘winning’ shots. So, for an amateur player, it is better to get the ball back into play as frequently as possible and rely on your opponent making more mistakes than you.

 

When applied to investment theory (Charles D Ellis was one of the first to do so) this strategy can have a number of interpretations. One that we certainly subscribe to is that professional and amateur investors alike will struggle to consistently play ‘winners’ in the short term. By attempting to pick consistently the best performing stocks over any particular short time period (a week, month or quarter, for example) – the equivalent of trying to play a winner on every point – one might pick a few stocks that shoot the lights out, but it is likely to come at the cost of a number of failures.  The best approach is to keep things simple, play your own game, concentrate on your defences and avoid the costly losing shots.... or in more conventional investment terminology, pick stocks that you believe will outperform in the long term!

 

For a comprehensive list of common financial words and terms, see our glossary here.

Liontrust Insights

 

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Some of the Funds managed by the Economic Advantage team invest primarily in smaller companies and companies traded on the Alternative Investment Market.  These stocks may be less liquid and the price swings greater than those in, for example, larger companies. The performance of the GF UK Growth Fund may differ from the performance of the UK Growth Fund and will be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product.  Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, November 17, 2020, 11:19 AM