Our approach is based on three fundamental tenets:
- Build an Appropriate Portfolio Structure – This will ensure you have sufficient cash to finance lifestyle and other goals as well as avoid being forced to sell shares at unattractive prices.
- Own Good Businesses – The best way to earn a satisfactory return on one’s capital is to own financially sound, profitable and growing businesses.
- Acquire Them at Attractive Prices – Acquiring a good business at a price that is lower than its fair value will result in a higher return at a lower risk.
Each of these is discussed in further detail below. While we view each tenet to be almost self-evident, applying them often requires us to take a position contrary to conventional wisdom.
1. PORTFOLIO MANAGEMENT AND ASSET ALLOCATION
We think the best way to grow your wealth is through the ownership a good business. Acquiring that business at a discount to its fair value further elevates returns and ultimately the size of your portfolio. However, as private investors, we also need cash to meet lifestyle or other financial goals. If an investor’s entire portfolio is allocated to owning businesses, where does the cash come from?
If you are working and earning a living outside of your investment portfolio then the majority of the portfolio can be invested into the highest growth asset, namely equities as the cash you need is available from your pay cheque. If you are solely dependent on an investment portfolio to support your lifestyle, then you will need to have investments converted to cash. One strategy to achieve this would see cash raised from the sale of shares whenever it is required. This is very risky since the price of a share at any particular time cannot be predicted. If the market will not offer a fair price when the investor needs cash, an inadequate return or even a loss can result. It is important therefore, that a portfolio be structured so that sales of shares are only implemented at a time and price of the investor’s choosing. To protect against a forced sale, a portion of the portfolio should be maintained in cash or short-term money market instruments. Therefore, we think that the cash component held in a portfolio should be the amount necessary to protect against a forced sale.
Genova takes the view that an appropriate cash allocation to protect against a forced sale for any investor is the amount of cash that is expected to be withdrawn from the portfolio over a typical market cycle of three to seven years. As mentioned above, an investor in the accumulation phase of life, who adds to the portfolio annually, requires virtually no cash. An investor dependent on the portfolio to support lifestyle expenditures may need say, 5 years of expenditures allocated to cash. The key point here is that the cash / bond allocation is not a percentage of the portfolio but an absolute dollar amount based on the particular investor’s needs.
Over a market cycle, the price of shares in a portfolio will rise and fall. The investor has the ability to choose the price at which shares may be sold in order to replenish the cash holdings.
This is why we focus on cash needs and time horizon rather than setting an arbitrary fixed target for each asset class. In this way, your portfolio will be crafted to match your life goals and designed for you to have the cash you need when you need it.
2. OWN GOOD BUSINESSES
There are many ways to make money. We believe that the most reliable way for private investors to accomplish their financial goals is to own good businesses. Whether the goal is to have a capital base sufficient to support a lifestyle either now or in the future, support and provide financial security for other family members or build a philanthropic legacy, the ownership of good businesses provides the basis for building core capital.
Conventional wisdom dictates that an investor should mitigate the volatility of a portfolio by including a significant cash or bond component. Since most private investors are taxable, holding cash and bonds results in a gradual but steady erosion of capital after tax and inflation are taken into account. However, they do have the advantage of short-term stability and predictability.
As you read in point 1 above, we think that cash and bonds should make up only that portion of a portfolio that is required to meet near-term spending requirements, with the remaining funds invested in the highest earning opportunity-namely equities. Cash and short-term bonds are also useful as a store of value when sufficiently attractive equity investments are unavailable. While this may increase volatility in a portfolio it doesn’t necessarily increase risk. In fact, it is the volatility in the market that creates opportunities to buy shares of good business below their value (a good thing) and because cash is available for lifestyle then the volatility will not impact your life day to day.
It is not enough to simply buy “equities” or equity indexes. Research done by Blackstar Funds in the United States indicates that almost two-thirds of stocks underperformed a broad index and that 25% of stocks were responsible for all of the market’s gains. It is also often said that an investor must diversify broadly in order to mitigate volatility.
Once again conventional wisdom turns out to be less than wise. Research (again in the United States) has shown that about 90% of the maximum benefit of diversification was derived for portfolios of 12 to 18 stocks.
Common sense tells us that a profitable and growing business will increase in value faster than the average business. Common sense also dictates that if one has a portfolio of say, 18 profitable and growing businesses, there is little reason to allocate funds to the 19th best company you can find.
So what is it that makes a business a “good” business? Obviously, there are many attributes that one would look for in a business in which an investment was contemplated. It is possible to draw up a checklist of attributes and assign a score to each as a way to evaluate the relative attractiveness of the business and all investors undertake this sort of screening process as a starting point. It is important however, to not let the checklist become the sole determinant of the decision-making process. Investing is as much an art as it is a science and there is no substitute for painstaking research coupled with good judgment.
Attributes that we look for in a potential investment in a good business include:
- a sustainable competitive advantage
- consistently high returns on capital
- consistently high free cash flow – profits that are not required to be re-invested in the business just to maintain the current level of profitability.
We like to see a well capitalized business, which generally means there is little or no long-term debt. This of course, is often a feature of businesses producing free cash flow.
We also look for a straightforward and understandable business model together with transparency of its execution, competent management and particularly important for a public company, competent ownership. Competent ownership may come in the form of a dominant shareholder, perhaps the founding family, having a strong interest in the long-term success of the business.
As noted, there are very few companies that will meet all the criteria that we look for so we must often evaluate whether strength in one area can overcome a weakness in another or comfort can be gained from a wide margin of safety between the price of a share and its value.
3. BUYING AT THE RIGHT PRICE: VALUE, PRICE AND RISK
You need to know the value of a business to know what the price you should pay to own that business. So, what is the value of a business? Common sense tells us that it is the present value of the company’s future profits – the value that accrues to an investor over the period of ownership. The price is something different. Price is the amount at which a share of a business can be bought or sold. A difference between the two can arise since future profits are unknown. Buyers and sellers may have differing views as to what the future profits will be or in many cases price is determined by the emotions of market participants with little consideration given to a rational assessment of future profits.
This leads to opportunities for an ownership focused investor. If an investor is able to make a rational assessment of future profits and thereby determine a fair price for a share of a business, he or she is in a position to prosper when the market offers a higher price for shares that he owns or a lower price for shares he wants to acquire.
In fact, and again contrary to conventional wisdom, an ownership investor will improve his or her return on an investment by reducing the amount at risk. Consider the situation where an investor could buy a share for $10, a price considered to be fair value. The expectation might be that the share will provide a return of 10% and be worth $11. Now consider the situation where the same share could be acquired for $5. Not only has the investor doubled the expected return but has only half as much at risk. By acquiring the share at a discount to its fair value, the investor has increased his expected return while reducing the amount at risk.
The achievement of a private investor’s financial goals is most likely when a strategy is followed that involves the acquisition of good businesses at attractive prices, coupled with a rational asset allocation. At Genova Private Management, we think that being an owner of a portfolio of businesses instead of a active trader is the best way to grow your wealth.