At Allan Gray we often talk about our investment philosophy. We’ve been investing the same way since establishing our Australian business over ten years ago and globally for over 40 years because over time it has worked.
Our approach rests on long-term valuation and patience. A sound long-term approach to investing does not need to be complicated; but to form a reliable long-term outlook you need to have conviction in your process. You can’t be patient without trusting your research.
Over the next few months we will publish a series of blogs focusing on our investment process. We want our investors to know how we get from our philosophy to constructing our Fund portfolios. In this introduction to the series we give an overview of two key aspects of our process and philosophy: valuation and patience.
We tend to be drawn to companies that have hit a rough patch, or are simply overlooked as a result of the latest investor fad. We think this starting point increases the chance of buying shares at attractive prices. We do not rely on stockbroker analyst recommendations; we form our own views based on our internal analysis.
We recognise that markets are forward-looking. A company may be growing or not, it may have higher returns on equity or lower, but what matters most is what is already priced in by the market. If the market price implies too much pessimism, even a mediocre business can make a good sharemarket investment, and vice versa.
Before we decide to buy the shares of a company for our Funds, we undertake a comprehensive evaluation of the economic fundamentals of the business. We want to understand how it earns its profits. We scrutinise its financial reports, going back in history as far as possible. We assess its competitiveness relative to other companies in its field, asking questions such as:
- Does the company have some type of advantage?
- Are there changes on the horizon?
- What is its position with suppliers and customers?
- What are the debts of the business?
- Does it have other lurking liabilities, such as environmental remediation commitments, future pension payments to former employees, or lease or supplier obligations?
- Does it behave as a good “corporate citizen”?
All of these factors help us to form a rough estimate of the long-term per share cash flows of the business. In turn this allows us to estimate a ‘fair value’ for the company (an imprecise measure that is often better expressed as a range).
We then compare this to the market value, which is the value implied by the current share price. If this is significantly less than our estimated ‘fair value’, we are interested! But first we try to understand why our view differs from the overall market.
If after further investigation we gain a degree of confidence in our alternative view on the company’s value, we are inclined to buy its shares for the portfolio. On average, we expect this to be a rewarding long-term approach to investing.
We recognise that we will not achieve a positive outcome on every company in the portfolio; unpredictable factors may be at play, our analysis could be flawed, or we might have to wait longer than hoped for our thesis to play out.
As such, we aim to maintain a prudent degree of diversification in the Funds; we do not put all of our eggs in one basket. But our objective is to produce a rewarding return for the overall portfolio, and we think it is hard (if not impossible) to do this without accepting uncertainty in individual company outcomes.
While the valuation process is not a simple one, it is probably easier than the second pillar of our investment approach – patience. We live in an investment world of monthly reporting, in which one year is often considered long-term. This is far shorter than our investment horizon of five to ten years. There is a constant bombardment of data (often of questionable accuracy or usefulness) and no shortage of daily opinions from pundits.
In this environment, it can be challenging to efficiently filter the ‘noise’. A willingness to stay the course is essential to an investment approach based on long-term valuation. The consistent methodology and analytical rigour of our investment process enables us to have the courage of our convictions. Though we retest our analysis along the way, we are prepared to ride out the short-term fluctuations in order to achieve our long-term objective.
The ultimate objective
We don’t use debt in the Funds to amplify returns. We diversify our holdings and disclose them quarterly. We keep it relatively simple – we invest in shares of ASX-listed companies based on our evaluation of their underlying value.
We hope that by clearly communicating our approach, we can win the trust of our clients so that they experience the long-term returns we seek to achieve for the Funds.