Our Investing Philosophy
An insight into our investing process.
Before diving into our upcoming publications, we want to take a moment to share our investing philosophy. A clear investment approach is crucial for everyone. By understanding our philosophy, you'll be better equipped to make sense of our research reports and other content, ensuring you get the most value from them.
Core Principles
Our investment philosophy can be characterised by the following core principles:
1. Asymmetry:
We focus our resources on highly asymmetric investments, prioritising opportunities with favourable risk-reward ratios. By only selecting opportunities with favourable risk-reward ratios, we aim to maximise returns while maintaining controlled exposure to losses.
2. Concentration:
In crafting our portfolio, we resist the temptation to diversify merely for the sake of diversification. By holding between 8 to 12 stocks, we strike a balance that mitigates company-specific risk while avoiding the pitfalls of over-diversification, which can lead to a portfolio that simply mirrors the broader market's performance without achieving superior returns. This focused approach allows for a deeper understanding of each investment, reducing the risks associated with spreading ourselves too thin and ensuring that every position we take is backed by strong conviction.
3. Long-Term Perspective:
Guided by strong conviction, we maintain a long-term perspective that insulates us from the noise of short-term market fluctuations. This patience allows us to harness the power of compounding and realise the full potential of our investments. Patience also comes in the form of being willing to "wait for the good cards," maintaining cash reserves until the market presents truly undervalued opportunities. This disciplined approach not only preserves capital but also positions us to act decisively when opportunities arise.
4. Contrarianism:
Following the crowd often leads to average results at best. To achieve better than average results, one must be willing to do something different. Being contrarian, however, must be tempered with caution. It's not about opposing popular opinion for the sake of it or because it suits one’s personality. True contrarian investing involves a deep understanding of the prevailing assumptions and a calculated decision to disagree based on thorough analysis.
5. Balance:
As we manage a concentrated portfolio, balancing our holdings becomes critically important. Management of our portfolio as a whole is just as important to us as stock picking. By carefully diversifying and opposing risks, we ensure that our strategy remains robust and adaptable, even with significant positions in individual stocks.
6. Approximations to Counter Uncertainty
Randomness and unpredictability are constants in the financial markets, making precise forecasts not only difficult but often misleading. We therefore recognise that investing is not about seeking certainty, but rather about navigating uncertainty. It is for that reason we prioritise being "roughly right rather than precisely wrong" in our assessments of intrinsic value. This approach focuses on well-founded approximations that provide reliable insights, rather than overly precise calculations that could lead us astray.
7. Risk Management:
Risk management is the cornerstone of our investment strategy. We prioritise a margin of safety in all valuations, maintain appropriate cash levels to navigate volatility, and ensure a deep understanding of the businesses we invest in. This disciplined approach is further enhanced by our barbell strategy. As we run a concentrated portfolio, creating slightly higher risk, we also hold substantial cash reserves as both a defensive tool and a strategic asset. Cash is the ultimate form of risk aversion. We see it as more than just idle capital; it is a powerful tool that provides us with the flexibility to act decisively when opportunities arise. Whether held in short-term treasuries or other safe vehicles, our cash is always working for us, even when not directly invested in the market. During periods of market exuberance, our cash holdings may increase, sometimes upwards of 30%, as opportunities become scarcer. In bear markets, when exceptional opportunities arise, our cash allocation may decrease significantly, enabling us to fully capitalise on these favourable moments.
Investment Checklist
Investing is a game of avoiding mistakes while capitalising on those made by others. The most effective way to succeed in this game is by using a tailored checklist, designed specifically to exploit others' errors and anchor our decision-making process. Below is the checklist we use to filter through companies.
1. Circle of Competence
Understandability of the Business:
Do you fully understand how the business makes money?
Can you explain the business model in a few sentences?
Industry Understanding:
How well do you understand the industry dynamics and key drivers?
Do you have a clear view of the competitive landscape?
2. Business Quality
Competitive Advantage:
Does the company have a substantial moat (e.g., brand strength, patents, network effects) that protects it from competitors?
How long can the business sustain its competitive advantage?
Are there any signs of competitive threats emerging?
Customer Loyalty:
How strong is the company’s customer base?
Are customer retention rates high?
Product/Service Differentiation:
Is the product/service meaningfully different from competitors?
How easy is it for competitors to replicate?
3. Growth Potential
Business Model Scalability:
Ease of Scaling: Can the business model be replicated across different markets or customer segments without significant changes?
Cost Efficiency: Does the business benefit from operational leverage, where increased scale leads to higher profitability?
Barriers to Scaling:
Regulatory Hurdles: Are there significant regulations that could slow down expansion into new markets?
Market Size: Is there a large, untapped market that the company can target, or is the market nearing saturation.
Capital Allocation:
High Return on Capital: Does the company have opportunities to reinvest capital at high rates of return?
Internal Growth: Are there existing projects or divisions with strong growth potential?
Innovation and R&D:
R&D Initiatives: Is the company investing in research and development to drive future growth?
Product Pipeline: Does the company have a pipeline of new products or services that could contribute to future expansion?
Expansion into New Markets:
Adjacent Markets: Can the company diversify into related markets or product lines?
Cross-Selling Opportunities: Is there potential to increase revenue by selling additional products or services to existing customers?
4. Management Quality
Capital Allocation Skill:
How has management historically allocated capital?
Are there instances of poor capital allocation?
Management Tenure and Stability:
How long has the current management team been in place?
What is the track record of the CEO?
Cultural Fit
Does the management team promote a culture that aligns with long-term value creation?
5. Management Incentives
Incentive Structure:
How are management incentives structured?
Are there potential conflicts of interest?
Alignment with Shareholder Value:
Do financial incentives align with shareholder value creation?
Do non-financial incentives serve strategic goals and add value?
Ethics and Outcome Alignment:
Do incentives promote ethical behaviour and long-term success?
Does the incentive program focus solely on outcomes and hence conflate skill and luck?
6. Financial Health
Balance Sheet Strength:
Does the company have a strong balance sheet with low debt levels?
Does the company have healthy cash reserves?
Free Cash Flow (FCF):
Is the company consistently generating strong Free Cash Flow?
Does the company convert a high percentage of earnings into Free Cash Flow?
Debt Management:
Is the interest coverage ratio high, indicating the company can comfortably meet interest obligations?
Are debt ratios (e.g., debt to equity, debt to EBITDA) conservative?
Profit Margins and Efficiency:
Are profit margins high and stable?
Is the company efficiently managing its operating expenses (e.g., SG&A, R&D)?
Risk Management:
Does the company manage its financial risks well, including fully funding pension obligations?
Are there any significant off-balance-sheet liabilities?
7. Valuation
Valuation is inherently subjective, often representing the culmination of insights gathered from the previous six sections. However, it’s still essential to consider the following:
Undervaluation:
Is the stock currently trading below its intrinsic value?
Discount to Intrinsic Value:
Does the stock offer a significant margin of safety, as calculated through methods like discounted cash flow (DCF) analysis or other valuation techniques?
How reliable are your assumptions, and how conservative is your intrinsic value estimate?
Reason for the Discount:
What’s the rationale behind the low price? Is there a fundamental issue, or is this an overreaction by the market?
Who is selling, and why? Are there motivated sellers, such as institutions needing liquidity, or is this a sign of deeper issues?
Assessing the Market’s Perspective:
Who’s likely making a mistake here—the buyer or the seller?
Consider the contrarian perspective: if the stock is undervalued, why hasn’t the market corrected the price?
7. Risk Assessment Checklist
Many risks have already been addressed through the detailed questions in the previous sections. However, the following additional risk factors should also be considered:
How vulnerable is the business to economic cycles, interest rates, and market fluctuations?
How dependent is the company on key suppliers, and how robust is the supply chain against disruptions (e.g., geopolitical events, natural disasters)?
Can the company quickly adapt to changes in market demand or operational challenges? What is its operational flexibility?
Is the business subject to significant regulatory risks or potential changes in laws that could impact operations?
Are there ongoing or potential legal liabilities that could affect the company’s financial health or reputation?
Are there risks associated with the company’s strategic initiatives, such as mergers, acquisitions, or new market entries?
8. Final Checks
Pre-mortem
Consider a view, looking back from 1/3/5 years in the future, that considers all of the ways in which this idea failed horribly; seek outside input
More vulnerable to Type I or Type II errors?
Type I error can be viewed as the error of excessive credulity; it is the notion of “seeing” something that is not really there.
Type II error can be viewed as the error of excessive scepticism; it is failing to “see” something that actually exists.
Confirmation Bias Check:
Challenge Your Assumptions: Have you actively sought out information that contradicts your investment thesis? Are you confident that you’re not selectively focusing on data that supports your view?
Objective Review: Have you taken steps to ensure that your analysis is as objective as possible, perhaps by involving a third party to review your reasoning?
Exit Strategy:
Clear Exit Criteria: Under what conditions would you consider selling the investment? Do you have a clear target price or set of circumstances that would trigger an exit?
Re-evaluation Plan: How often will you revisit and re-evaluate your investment thesis? What signs will prompt you to reassess your position?
Conclusion
While we adhere to our core principles and use a checklist to evaluate each investment, it's crucial to remain open-minded and adaptable. We try and avoid tunnel vision and remain willing to consider other factors as they arise. Flexibility is key.
Overall, our investment philosophy emphasises preparation, patience, and adaptability. By staying true to these values, we can navigate the complexities of the market and consistently deliver sustainable, long-term value for our investors. This approach ensures resilience across market cycles, allowing us to capitalise on opportunities while effectively managing risks.
Individuals that have inspired our philosophy and strategy:
Nassim Nicholas Taleb, Charlie Munger, Warren Buffett, Chris Mayer, Chuck Akre, Seth Klarman, Howard Marks, John Maynard Keynes.
Disclaimer: The content provided in this newsletter is for informational purposes only and does not constitute financial, investment, or other professional advice. The opinions expressed here are those of the author and do not necessarily reflect the views of Schwar Capital. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The author may or may not hold positions in the stocks or other financial instruments mentioned. Always do your own research or consult with a qualified financial advisor before making any investment decisions.
Great check list. It would be great to see it in action on one investment case?