In his recent blog post, Dr Justin Koonin explained the methods we use to come up with the shares that we think will be our nuggets of gold. Now, in this third post in our blog series about our investment process, Dr Suhas Nayak explains how a share gets from the shortlist into the Fund portfolio.
If a share screens well in our quantitative screening process an Allan Gray analyst might research it further. It’s worth noting that the team does not have a rigid process for research. This is not only because every share is different. It is also underpinned by the belief that the market is very efficient at finding and implementing so-called ‘bullet-proof’ processes only to make them anything but bullet-proof. There are four tests a company must pass to make it into the portfolio.
Financial statement interrogation – stage 1
An analyst may spend two to three weeks researching a share in a first round. This normally involves interrogating the financial statements of the company, as well as those of its competitors. We typically go back as far as we can to try to understand what drives a company’s earnings and cash flows.
The goal is to understand what causes profits to rise and fall and to understand where we are in that company’s business cycle (i.e. whether profits are high or low relative to normal). Whilst we don’t consider the macroeconomic environment, if every company in the industry is making a lot of money (e.g. high returns on capital), then it would be unusual for us to get excited, as it’s likely that either this is already reflected in high share prices or the high level of profitability is unsustainable.
To further investigate the companies we are interested in we then like to meet face-to-face.
Face-to-face meetings – stage 2
While interrogating financial statements can help determine a company’s earnings drivers, face-to-face meetings with the company, competitors and other analysts can help refine hypotheses and check if anything important has been omitted. We are often asked how much value we place on these meetings. Undoubtedly they are crucial to our investment process, but it is vital to remember that most participants have their own vested interests. Seldom do management teams tell it to you exactly as it is and other market participants often have shorter time horizons than us.
Valuing the business – stage 3
From there, we try to understand the value of the share, but to understand this we really need to know the value of the business. If we were to own the company for a long time, what can we expect to get in return? Various fundamental valuation methodologies may then be used (e.g. a discounted cash flow or some sort of price to book ratio). The trouble is that most analysts use these and it is important to understand the flaws. In particular, assumptions can really drive the valuation, which means while the methodology may seem scientific, emotional changes to assumptions can quickly make the process anything but ‘science’.
After we’ve gathered the factual information needed we have to assess whether a share deserves a place in the portfolio. We try to look at the company in a number of different ways. Some of the questions we try to answer include why someone would sell their shares to us (after all, we’re probably not the only ones thinking we’re getting a good deal!), how bad could profits get, and what are we paying today for those earnings? We try to focus on the downside because, when shares are classically contrarian, it is the fear of the downside that drives prices to ever-lower levels.
Investment committee meeting – stage 4
An analyst may return to research a company a number of times before deciding it is good value. This may happen over a period of months, or even years. But once this determination is made, the analyst will typically schedule an Allan Gray investment committee meeting.
All seven of our analysts attend the investment committee meeting. The analyst calling the meeting circulates a report on the company, which outlines the investment thesis and provides a background to the industry and the company’s profits. This normally elicits questions from the other analysts, and then another question and answer document is typically circulated before the meeting.
Our investment committee meetings are the most important meetings we hold. The outcomes drive portfolio construction. All analysts typically do a lot of work ahead of the meeting to test their own understanding of the company and the assumptions underlying the investment thesis. Debates can be robust and the analyst’s work is cross-examined extensively by the others. It would be unusual for there to be consensus at the end. Votes are typically taken ahead of the meeting and then again after the meeting.
The portfolio managers then decide individually, based on the discussions and the information to hand, whether to purchase the share for client portfolios. But even once that decision is made, acquisition of shares is typically characterised by patience. We don’t rush in and buy the entire portfolio position immediately; instead we buy on share price weakness and gradually build a position.
After all, our portfolios are built for the long term.
Dr Suhas Nayak holds a Bachelor of Science with Honours (California Institute of Technology) and a Doctor of Philosophy in Mathematics (Stanford University).