- Ryan Reeves
Our Investment Process
The philosophy is about finding the fastest-growing, highest-quality businesses in the world at the lowest valuations we can find. Fast growth indicates a superior product or some tailwind. And operating leverage and solid unit economics, reveals some superior execution. We want to find companies that are growing their underlying earnings power extremely fast. And in a perfect world, we want the investment payback period to be as short as possible. Oftentimes, this is the variable that is lacking so that requires a stronger belief in the sustainability of growth through things like studying the market structure, competition, and management.
We believe there are 3 legs to good investing — growth, quality and valuation. Most investors seek to focus on just one. We try to get all three. Valuation can be the trickiest because we’re dealing with exponential growth so that is the one we can compromise on the most out of the three. That’s because time is the friend of an amazing business and we seek to hold for as long as possible. That’s not to say we buy and hold forever. We constantly verify the strength of the holdings against one another and against the universe of companies that are growing their earnings very quickly. A prototypical company would be a leading company with a founder-led CEO in an industry with tailwinds that is growing revenue 50%+ with positive free cash flow (50% isn’t a precise number as it depends on the opportunity set).
On valuation, we prefer to get paid back from the company's estimated free cash flow over the next 10 years. We think that buying a stock should be assessed just as if we were to buy an entire business. To zoom in a little bit we also use a 5-year model with reasonable assumptions to see what is priced into the stock. If forward returns are too low, we may trim some if we hold it or not buy the stock if we’re looking at it. Our hurdle rate is 25% (but of course, it’s not a perfect science). We are not necessarily trying to find companies with super established moats like Moody’s or Visa but companies that are in the process of building their moats. This involves more execution risk but the rewards can also be much higher. That’s why we constantly verify because sometimes the competitive dynamics can shift. We typically keep a very concentrated portfolio of between 6-12 stocks for this reason. We seek to know each company better than even the employees in that company. It would be incredibly difficult to know even 15 companies that well.
The process (the input) that leads to the output of the portfolio first goes through the filters of underlying earnings growth. If the company’s growth is decelerating in a major way and margins are deteriorating, it’s an easy pass. After all, with thousands of choices, we need a way to filter so we can focus on the things in our circle of competence. However, there is always nuance. If a company’s revenue is accelerating, we give leeway to the margins because it is likely that the company is reinvesting huge sums back into the business. Despite this headwind, the uptick in revenue growth can still mean supernormal earnings growth. We also don’t mind if earnings are negative, although we certainly prefer profitability. When companies want to take advantage of a strong tailwind and the customer acquisition costs are far lower than the lifetime value of those customers, it actually makes sense to step on the gas. Sure, some companies view this as too risky but it actually makes economic sense. If you had access to a machine that spits out money, it might not be a bad idea to put nearly everything you had into that machine. You need to be pretty certain about the longevity of that machine, but your opportunity cost would simply be too high to not utilize that. One reality of business is that it costs a whole lot less to retain a customer than it does to acquire a new one. What we’re trying to get at is that there is nuance to the process. Negative doesn’t necessarily mean bad, as long as the incremental margins are strong.
Once we filter companies using these simple criteria, here’s where the fun kicks in. Our filter is pretty quantitative but then, using our qualitative process, we try the best we can to disqualify our potential candidates. It’s sort of like SEAL training. We’re trying to weed out the weak. The first test allows us to fish in a pond of likely winners but then, the successive tests only leave the strongest standing.
We mentioned it already, but the first test gets at the growth piece of the equation, and the next set of tests deals with quality. Quality is a tricky thing to define but it mainly has to do with durability, in an investing context. Sure, growth can be good now, but if it’s not sustainable, it’s not worth much. So what are the factors that contribute to sustainability?
There’s a whole lot but one thing we look for is win-win-win relationships. We love companies that are doing well by their employees, customers and shareholders. If one party is losing, then it’s a pretty easy pass. And quite honestly, shareholders are the least important in our opinion. Customers drive profits and employees create the products and services that customers use. So if these two parties aren’t incredibly happy, then there is a good chance that shareholders, in the long run, won’t be either.
To understand these dynamics, we study customer habits and how irreplaceable the product/service is. And we also make sure to get a sense of the company culture and what differentiates it. After all, companies are just collections of people and processes. Without the ability to attract great people, great products won’t exist.
Studying win-win-win relationships gives us a sense of the value created by the business. But studying the market gives us more detail about the value capture. And these two aspects, value creation and value capture, lead to long-term cash flow. If a company can create a ton of value, but is unable to capture any of it, it won’t gush cash in the long-run. Obviously, value creation and capture go hand-in-hand because it’s likely that you will capture more value if you create more, but it doesn’t always work that way. If your business operates in an incredibly competitive space and there are worthy alternatives, customers don’t need to rely on you. To study this, we use two simple mental models:
Opportunity = magnitude of moat * size of the market
Revenue = price * quantity
These models are saying very similar things. A business won’t be able to grow cash flow at extremely high rates without a big market. But in order to satisfy and retain customers, it needs some sort of advantage or else the magic of capitalism will do its thing. Another name for this is pricing power. If a business raised its prices and tons of customers churned, then the moat must not be super large. That doesn’t mean we like it when companies raise their prices. In fact, I’d rather the value that customers get from the product severely outpace any price increases. It goes back to the symbiotic nature of value creation and value capture. However, the degree of competition usually affects the latter. Ideally, we are looking for singular companies. Companies that don’t have “real” competition. The reality of business is that everyone has competition. But some companies have such a far lead, that it is very unlikely for competitors to catch up or make a dent in the business. Or maybe the competitors have just botched it. Or maybe the company got a lucky break in the early days and never looked back. Whatever it is, there is some reason why the company can capture more value than competitors. When this is the case, these companies can create even more value and the cycle repeats. It’s very difficult to catch a company in this virtuous cycle. So that’s why a rather large part of our process is studying competitors. If there are lots of worthy competitors, it’s likely that the company won’t move through our funnel.
But once again, companies are just collections of people and processes. Value isn’t created and captured on its own. So the management team and the ability to attract top talent is important to understand. Founders with skin-in-the-game is our preference but—if the moat is strong—not a necessary criteria. We do strongly prefer management teams where the business is their baby. An ownership mindset is a powerful force. Management is arguably the most important thing because they are the ones that set the tone for the value creation/capture which leads to long-term cash flow growth. However, if the business isn’t executing, management’s pedigree isn’t a thesis in itself.
To get practical, we read and listen to every interview by management, as what they say is important for the business. This gives us a sense of their character without being biased by meeting them in person. In fact, that is not a requirement of ours. Some managers will only buy a stock once they meet with management. Our view is that it can actually bias our process since CEOs are typically incredibly charismatic. There is usually quite enough public material to get a sense of who they are. In fact, our preference is getting reference checks from current and former employees. I know most businesses don’t even do reference checks for hiring but it is our belief that they are most helpful if done in a thorough way. People can always spin a good story about themselves but if everyone says they are lazy/incompetent, then they’re probably lazy/incompetent.
Lastly, we look at valuation. This is because we find it quite difficult to estimate the value of the company without a sense for its earnings growth and the durability of that growth. So that’s why the majority of our time is spent on the first two legs of the growth, quality, valuation trifecta. Some investors do a great job of buying a beaten down company, but that is generally not the pond we fish in. We are ideally looking to let the earnings growth do the work rather than the multiple.
Our actual valuation process doesn’t take too long as we’ve already done hard work to estimate the size and strength of the business. We estimate the cumulative free cash flow for the business and see if it would pay us back over the next 10 years. If it's not even close, we'll put it on a watchlist and be patient. In tandem with this, we also look out five years and get an estimate of earnings with a reasonable valuation multiple and get the implied CAGR. Our hurdle rate is 25% but we do actually lower it a little when we are holding a stock for tax efficiency reasons. Further, when we hold a stock, it’s one that we know well and we think it’s fair to let it get a little overvalued. Some of our biggest mistakes have been trimming based on valuation alone. Winners tend to keep winning.
That is our broad process – keeping incredibly high standards by finding companies with high growth, high quality and low valuations. It turns out that very few companies can satisfy each of these criteria. That is another reason why our portfolio tends to be concentrated. Even getting the first two legs of the trifecta narrows down the universe immensely. And finding reasonable valuations can be quite tricky. This can create some problems because we don’t like holding cash. Probabilistically, it is usually an error. However, when valuations are stretched, that is sometimes the only thing to do. We very rarely engage in short selling or buying options. In fact, our philosophy is basically the reverse – companies whose growth is rapidly decelerating and they are losing more money. Moreover, untrustworthy management teams who don’t prefer win-win relationships. However, the simple upside-downside math is such that we spend more than 95% of our time and attention on the long side.
We are business analysts through and through. We start with the filter of underlying earnings growth and then disqualify companies through the quality and valuation tests. The remaining few companies then enter the portfolio. Position sizing is a function of a few things – namely, upside and conviction. Upside generally means the valuation is lower and conviction refers to the quality. In the three-legged stool, there are ranges. Just because all the companies might be founder-led, some could be 10x better than the others. The same even goes for things like revenue growth – if customer habits are recurring, then the durability is likely higher and so the company might get a higher quality score. Position sizing is not a perfect science but you can think of it like a scoring system. We go through the growth, quality, and valuation frameworks and then the companies who score the highest, get the biggest positions. Every day the companies in the portfolio need to earn their spot and they are all vying for the top dog position. But there is extra responsibility as a top dog– more scrutiny! We try to line up the amount of time we spend based on the size of the position. But this has a downside as well. The more information we learn about a position, the harder it is to make blank-sheet decisions. What we mean by this is that every day is a blank slate. Ignoring taxes, would you buy your current portfolio, in all the same allocations, if you woke up with 100% cash in our account? If your ideal portfolio looks much different than your current portfolio, the good ole’ endowment effect is probably at work.
We also want to point out that the process is always adapting. We are always learning new things and putting more emphasis on certain dynamics. Business evolves and therefore, so should our process. At the end of the day, cash flow is king but how companies create and capture value evolves because of new innovations. People will want better lives and cheaper products, but the delivery mechanism will change over time. Our goal is to study the very best companies over the ensuing decades, building a library and knowledge base that is incredibly difficult to replicate. And we intend to do that one day/annual report at a time.
Interested in Infuse Asset Management? Let’s talk.