The Imitation Game

by Joao Alves, Ahead Of The Crowd

In the spirit of recent quarterly investor letters, this post is PART 1 of a series that will address the arcane challenge of idea generation in investing. The emphasis is on scanning funds’ holdings.

The contents of the three posts are the following:

PART 1: focuses on discussing a way of sourcing for ideas, which is to scrutinize funds’ holdings to find a handful of ideas that meet one’s criteria for investing.

PART 2: focuses on applying the framework laid out in Part 1 to an example, FPA’s International Value Fund, and showing how the process moves down to finding a handful of investment ideas to add to one’s watch list.

PART 3: focuses on describing two key ideas from FPA’s International Value Q3 Commentary (EssilorLuxottica and Ryanair), and the key quantitative and qualitative elements that drive those two companies as compounding investments.

PART 1

Intro

This piece focuses on discussing [one] way of sourcing for ideas, which is to scrutinize funds’ holdings, and I present a system for (1) choosing funds, (2) analyzing their merits and shortcomings when it comes to scouring their portfolios for ideas, and (3) screening ideas generated and invested by the respective funds.

The rationale is that by following great funds, which have a history of success in investing, investors can leverage off of smart people’s efforts to increase the probability of finding more compelling investment ideas.

I firmly believe in the value of this exercise, because I have a hypothesis: sources of information are perhaps the main differentiator in the pursuit of alpha. As the legendary military strategist, Sun Tzu, once said: “Every battle is won before it’s ever fought.”

Context

One must be holistic when searching for ideas. Although I prefer to follow hedge funds – given their absolute-return orientation – I tend to follow mutual funds as well, as they disclose more information about their holdings and are often more detailed when talking about them in their filings. Generally, given my somewhat global mandate (Western Europe, Canada, and Brazil), I tend to follow mostly firms that invest globally as well.

But that’s not a necessity – I just want to follow and read about funds and managers that are smart, eloquent and original in their thinking. This stimulates my creativity and helps improve my reasoning.

Some of the funds I follow – with their recent letter/commentaries – are the following*:

Large and famous ones like:

• Absolute Return Partners
• Centerstone Investors
• Evermore Global Advisors
• First Eagle Investment Management
• FPA International Value Fund
• Harris Associates
• Oakmark International Fund
• Sequoia Fund (Ruane, Cunniff & Goldfarb)
• Third Avenue International Value Fund
• Tweedy, Browne Fund Inc.

As well as smaller value shops like:

• Bayes Investments
• Boyar Value Group
• Curreen Capital
• Greenwood Investors
• Unslope Capital Management

Dissecting Framework

Even though I’m not looking to invest in the fund itself, my way of looking at funds is similar to that of analyzing a company.

I want to understand the nature of the company and its advantages, the results that the company has generated, the people managing it and making meaningful decisions (where and how they look for ideas, how they analyze/vet/decide on them), the corporate culture, and the incentives structure in place.

The system I use can be broken down into three components:

1. Choosing the fund’s to follow;
2. Evaluating the merits and shortcomings of funds’ sources of information, in terms of when it comes to sourcing for ideas from the amount of information they provide about their holdings;
3. Screening for ideas that are in line with my investment criteria.

We must also bear in mind that some variables are easier to know than others; therefore, one must adjust the weighing of the variables in their analytical process accordingly.

Component 1: Choosing Funds

The key elements I look for are the following:

• Company (Investment Philosophy and Process): I like to follow funds that have a tested investment philosophy and are consistent in applying it, and sticking with it through cycles; show rigor of analysis and have a repeatable process, with [preferably] a concentrated portfolio; and that tend to invest with a global mandate
• Management/Corporate Culture: I like to follow funds that have the discipline, relentlessness, and capacity to execute an investment strategy over the long-term.
• Alignment of Interests: I like to follow funds where the managers’ and employees’ capital is invested in the fund, and thus their interests are directly aligned with their investment decision-making efforts, as well as the investment philosophy of the fund.
• Track Record: And last, but definitely not least, I only tend to follow funds that have a long-term track record of success, usually over a 5-year period of consistently beating of the market.

Altogether, these elements speak to the credibility of the funds’ ideas.

Component 2: Evaluating Funds

My process of going about screening funds’ holdings is slightly different from the framework laid out above. The framework serves to identify the hunting grounds; the process serves to reap/harvest the seeds.

Why is this all so important? Because in order to understand whether the ideas generated by the fund are advantageous to alternatives, it’s necessary to have a view on whether the firm itself – the people who conduct the research – have an advantage over the rest. Knowing where the people and culture are coming from helps understand the merits and demerits of their analysis, and helps focus my energies.

The usual steps I take are the following:

1. After finding the right funds to follow, I analyze the strengths and weaknesses of the managers’ analysis.
   • How do I do that? I first gauge how the fund writes about their investments by reading a few past commentaries, conference call transcripts, interviews with mangers, etc. I want to know not only what they talk about, but also how they talk about it. For example, some funds zoom in on the company’s business model, some on the macro environment or industry, some on management, and so on. I try to identify what does the specific fund I’m looking at tends to focus on, and especially, leave out. This says volumes.
2. Then I go to the funds’ current portfolios and look at the top ten holdings. I also check for any portfolio updates; what has changed in the last year, and the respective quarters during that period.
   • Here, I want to understand the funds’ holistic strategy and market positioning, in terms of their weightings in each industry and/or geography, turnover rate and cash position. This gives me more context to understand why they are invested in each specific name they talk about.

This all helps add perspective as to their investments and understand the rationale for the overall portfolio. I like to think that this is a good way to begin digging into their holdings.

Component 3: Screening for ideas

Having done all the grunt work, I move onto the content of the quarterly commentary/letter, applying my criteria for investment typology to screen for possible investment candidates.

This represents the sort of elements and patterns that I look out for when searching for ideas, which fall into one of two categories: (1) a special situation, either corporate or otherwise, that creates a mispricing; and (2) a combination between business quality and whether the stock is attractively priced.

My categories resemble that of Christopher Begg’s of East Coast Asset Management:

• Category (1) would be a combination of Begg’s “Transformations” and “Workouts” (which are similar to Buffett’s “Workouts”), and category (2) would be similar to his “Compounders” (which are similar to Buffett’s “Generals”).

This is important to define because, as Begg puts it ever so clearly, “Sourcing portfolio ideas into these [three] categories help us frame the opportunity in a way to determine our investment edge and also drives a targeted checklist as we give due diligence to the idea.”

1. Category 1 is about looking for companies that present a sign or opportunity for price dislocation.
   • The usual candidates fall in one or more of the following situations: activist campaigns; spin offs; rights offerings; M&A’s; litigation and other legal issues; balance sheet recapitalizations; and general turnarounds. I want to say “no” quickly to ideas/situations that don’t seem worthwhile for my objectives as an investor.
2. Category 2 is about searching for quality assets and/or people in which I can invest in at an attractive price. Buffett’s and many others’ success show that opportunistic quality investing is a winning strategy over the long-term.
   • This category is a function of companies’ returns on capital over its lifetime, as well as the people running the business, the state of the industry and competitive landscape it belongs to, and strengths and weaknesses of the company’s business model.

I always check to see whether the business has sufficient quality to weather storms (and preferably, if there’s proof of the company having done so similarly in the past). I want to see whether the business model has changed over time, how it stands today, and who are the individuals making the tough decisions. Again, it goes back to the framework used to choose a fund to follow in the first place: Component 1 of the system.

Quality isn’t as simple as a high ROIC, or high market share, or high margins. Quality is a dynamic concept. It’s a set of traits and patterns that a business displays, which explains how they are able to transcend traditional competition theory (the fact that high returns on capital brings more competition, and thus lowers those returns over time) and overcome the forces of mean reversion.**

Final Thoughts

By applying all these steps, I’m able to better understand what I can trust to be [most probably] true, and what I can disregard in my own research. This saves loads of time.

I’m then able to more efficiently move to deeper investigation. This consists of the following detailed valuation work (to assess what’s the price being charged to run risks that go with investing in the respective companies and if it’s a fair one), and thorough competitive analysis in terms of evaluating management’s historical decisions and their strategic plans for the future. The goal is to determine whether the firm’s economic moat is emerging, shrinking, or expanding.

The true gem is when both categories overlap – both a mispriced situation and a quality asset that I can purchase at an attractive price. That’s when I have a large spectrum of what can go right with an investment amid all uncertainty.

Part 2, will then cover the application of the system laid out above, to an example, FPA’s International Value Fund, in order find a handful of investment ideas to add to one’s watch list.

* * *

* A more comprehensive list of some global value investing funds can be found in John Mihaljevic’s book, The Manual of Ideas: The Proven Framework for Finding the Best Value Investments.

** Quality Investing: Owning the Best Companies for the Long Term by Lawrence A. Cunningham, Patrick Hargreaves, and Torkell T. Eide. I highly recommend this book, which I’ve recently read. It goes into detail about the patters and qualities that comprise a quality company, as well as provides case studies about some of the best companies in the world.