This is a question I have always struggled with. I have made successful (and unsuccessful) investments from both the ‘value’ and ‘growth’ camp, and I subscribe to the Marks-ism that ‘value’ investors are focused on value today, while ‘growth’ investors are focused on value tomorrow, but they are essentially the same thing.
The problem is that I have been unable to identify the specific process that is my edge or my niche. Once you identify your precise skill-set, it becomes consciously manipulatable, leverageable, and ultimately, marketable. It is uncomfortable, not knowing what you are good at. But after many years of thought I think I have figured it out.
My investment style:
My investing style I’ll call ‘mechanical’ investing. I look for multiple moving parts, like cogs in a gearbox, that might be manipulated to drive a company forwards while also preventing it from reversing. I realise there are also quite severe negative connotations to ‘multiple moving parts’ in an investment, but let me explain:
To use a 10foot example, I bought Eureka Group Holdings Ltd (ASX: EGH) because I thought a couple of things would happen.
- $$ would be unlocked through Terranora sale and development (either lower debt or ploughed back into development)
- Continued acquiring of 11% gross-yielding properties (and company is small enough for this to move the needle)
- Plough cash back into development/ acquisition, leading to some scale benefits
- Once it gets some scale, net yield on 11% should improve and it should be able to continue growing for quite some time just on existing cash flow (this segment of market is largely untapped)
- Some potential to lift rents, although as mentioned previously I would not be keen on this. Can also sell value-add services etc.
- Once that scale is achieved, it’s very hard to see the company going backwards in terms of their size and operations
- Overarching tail wind of ageing population, minimal competition at present and high latent demand for Eureka properties
Of course there are many ways they can muck it up, too much debt, poor service, low occupancy, poor investment decisions, blah blah. But the point is that if the above things happen, and they are investment grade probabilities, it is very hard to see Eureka being eradicated from the market or being unable to grow further. If competition heats up, debt gets too high, or the market starts to look saturated, there should be ample advance warning. This is the kind of business evolution process that I look for.
‘Mechanical’ investing to me means the moving parts that, when locked in place, create value that is unlikely to be transient or easily competed away. Importantly, once one part becomes locked in place, it provides the footing for the next part to be built on top of it, cumulatively adding value with a lower likelihood of reversal.
Importantly, the mechanical process is not binary and the chain of value creation ideally cannot be broken by any one single thing going wrong. Eureka could be regulated out of business or perhaps its value proposition loses in some way but in each of those cases the destruction is a process. I don’t think you can have a ‘mechanical’ investment opportunity that involves any binary premises. For example, reliance on a single customer or a single thing, like Google flight aggregation can generally make it difficult to layer value on top of value, or at worst the multiple layers of value (e.g., flight aggregation, then value-add via accommodation, packages, car hire, etc) can be a house of cards brought undone by a single failed element.
There are plenty of other things that have to be checked out before an investment can be successful. This is simply to describe the type of situation I look for. Not all investments fit this mould, even in the 10foot portfolio, but this is my general approach.
What is my specific edge?
I’m still considering this, as my investment style is hardly proprietary. Work in progress.
I have some preliminary thoughts. I recently saw that a portfolio manager that I respect is long Chinese e-commerce giant Alibaba despite a seemingly damning list of red flags. I don’t know anything about the company but I questioned how an investor could take a position without addressing the elephant in the room of these allegations, which are so convoluted as to be probably impossible to ever unravel? The answer I came up with is that perhaps confirmation bias is at play – the investor sees what they want to see, such as certain metrics moving in the right direction, and seemingly doesn’t need to counterthink them.
My edge (and admittedly it’s not much of one) is that, as an amateur, I am not paid to manage money and others have not tipped their hat to my genius by giving me their money to manage. So I have an enormous amount of self-doubt, amplified a hundredfold by exposing my thoughts to the public view, and I am perpetually asking ‘how is this company going to fuck me? is this company going to blow me up in front of hundreds of people I respect?’ I have done some dumb stuff, and will do more dumb stuff (guarantee it) but I don’t think I would ever make a fraud-like level of mistake – or at least if I did I would be very open to the idea of being wrong. On balance I expect this will lead to an urgency/ willingness to work harder that some professionals may lack.
What I’m not good at:
I am historically not great at making countercyclical investments. It is hard for me to grasp that demand can materialise from thin air. I know that it does not literally come from nowhere, and that is possible to see the leading indicators of demand building, but psychologically I struggle to grasp that there can be new demand for businesses that were being slaughtered wholesale just a few years prior. This sounds a lot like anchoring, although I believe it is slightly different. For example I am aware of cycles, but I struggle to forecast the likely future demand and margins for cyclical industries, even with history as a guide.
That’s unfortunate because other than this, I am psychologically quite suited to countercyclical investments. This is due to my affinity for narrative, as well as the fact that cyclical industries (i.e., capacity declining leading to higher prices) are fairly ‘mechanical’ in nature. This is something I am working at improving and I shall see where it leads me.
I am also historically poor at picking high growth companies (though I have been fortunate with a few nice ones in recent years) because the idea that ‘hey, this company has a new product, there’s a monstrous target market, sales are already going to the moon’ does not click with me psychologically.
However, I do own (outside of 10foot) a couple of high-growth technology companies with ‘mechanics’ that look like this:
- High retention
- Good sales at decent margins and adequate cash reserves
- Likely customer lifetime value is greater than cost of acquiring customers (incl network effects/switching costs, upsell potential etc)
- Run huge persistent operating cash flow deficit acquiring many customers as possible (without cannibalising brand/pricing etc)
- Watch embedded value (however you choose to measure it) grow over time
- Cash flow grows in line with revenue, and over time as the company grows to maturity in its market the value of existing customers exceeds the cost of acquiring new ones
- Large captive customer base to leverage with new products or higher prices over time
These stories are intuitively appealing to me and I am more comfortable investing in these circumstances, despite seemingly high P/Es, because I can more easily see the ‘mechanics’ of how the value is being created, and I can grasp the ways in which more value can be unlocked than is suggested by current earnings or even forecast revenue growth.
Future investments will likely come from all kinds of fields, wherever I can see an attractive ‘mechanical’ scenario playing out. I would be glad to hear your thoughts on this one, particularly if you think there is a flaw in this approach, so do feel free to leave a comment below or email me at email@example.com.
Of the companies mentioned in this article, I own shares in Eureka Group. This is a disclosure and not a recommendation.