At Allan Gray, we focus on investing in businesses rather than trading in shares. When we select companies for our portfolios, we try to get a deep understanding of how a business operates rather than guessing how the share price will move next week or next month.
Our long-term approach means that we think like business owners and as a result, our clients become business owners. This is a very different mentality from trading in and out of stocks trying to make a quick profit.
Company valuations are our bread and butter
The sharemarket is a very efficient machine which usually sets the price of shares at a level that reflects the future prospects of the company.
However, we believe pricing mistakes can sometimes occur when short-term sentiment overrides longer-term company prospects. In order to take advantage of these situations, we must have a clear idea of what the long-term value of a company is.
Our valuation process relies on a detailed analysis of the company’s business model, operating divisions, competitive position, industry dynamics and management capability. We want to determine exactly how and why the company is able to make money from its operations.
Our valuations are based on long-term data and trends
We always look at the financial statements of the company and its competitors, going back over several decades if possible. We aim to determine the normal levels of profitability in the industry over long periods of time. We also assess how sustainable we think the company’s operations and financial returns will be in the future.
Many of the shares that we select for our portfolios are out of favour with the investment community because of temporary difficulties in their operating environment. By assessing these longer-term financial metrics, we have an important historical context against which to interpret any adverse developments.
Watch out – valuation can be an inexact science!
Fund managers use many different tools to estimate valuation. At Allan Gray, we normally estimate a company’s value by using several approaches because the importance of each one can vary between companies and industry sectors. We also keep in mind that financial spreadsheet models can be very sensitive to small changes in inputs such as long-term growth rates and discount rates.
A margin of safety is the investor’s lifeboat
Since valuation can be an inexact science, we insist on a margin of safety between the price we pay for the share and our estimate of the long-term value of that share. This margin of safety approach enables us to reduce the chance of a permanent loss of capital.