In 1941, Einstein famously declared that “science without religion is lame, religion without science is blind”.
In the world of investing, this holds just as true if you replace “company research” with “science” and “valuation” with “religion”: the most detailed and accurate research is useless unless you also have a buy or sell decision based on valuation; similarly, an investment decision without a fundamental understanding of a business is no better than investing on the roll of the dice.
In previous articles, we’ve shared our research, including the themes we like and our best research ideas – the top ten holdings. However, identifying good companies is not enough. To succeed as a fund and successfully deliver consistent significant outperformance for our investors, we must convert insights gleaned from our hard work into action – and an important component of that process involves how we approach valuation.
Our views on Valuation
“Price is what you pay, value is what you get.”
This was what Warren Buffett reminded investors in his 2008 letter to shareholders. When we talk about valuation, we are laser-focused on the value that we’re paying for. Specifically, it’s the cashflows and the certainty of those cashflows coming from a business which give it value. This makes valuation intimately linked to our research process.
The research process is scientific: we can model a business based on detailed analysis of structural trends in the end market, the level of competition within the industry, and company-specific factors, then test our assumptions for projected cashflows against what the company delivers.
This takes a lot of hard work – it involves going to primary sources and industry publications to understand the dynamics of the sectors we’re looking at, trawling through company filings at the exchanges to build our own models and, most importantly, exercising good judgement when making assumptions for our own forecasts. We have dedicated significant resource to guarantee the quality of our research from day one.
Based on the conviction of our fundamental research, we often find opportunity where the market systematically underestimates longer term growth. This happens when the market price reflects consensus estimates of future growth rather than what is implied by our research. This is when we buy.
For the same reasons, when the market is getting ahead of our expectations, we will sell or find more attractive alternatives. This is why we reduced our position in Amazon in July 2020 and why we held more cash at the end of 2019 – putting us in an excellent position to top up our highest conviction holdings during the sell-off in 2020. This is how we exercise a strict valuation discipline.
The flexibility in our approach to valuation is that we are sector-agnostic. Right now, we see more value among high quality companies like PayPal, Amazon and others in the “tech sector”. If we see consumer staples companies demonstrating value like our “tech” holdings, then they too will feature more prominently in our portfolio.
What about macro?
We are often asked about our views on “macro” – encompassing both geopolitical and macroeconomic events. We answer every time that we do not take a view on how events will necessarily unfold – that requires predicting the unpredictable which is a fool’s errand – but we do take a view on how events could impact our portfolio at the company level, specifically, how it would impact the expected future cash-flows of our portfolio holdings.
This again is where our research process is intimately linked to our valuation framework: only with a sound understanding of a company’s business model can we reliably assess how it performs in adverse conditions. We stress test a company’s cash flows and earnings and if, even with conservative assumptions, the company fares better than consensus estimates, then we can have conviction that value is there. The majority of companies in our portfolio have passed such a “macro stress test”, and this was why our portfolio fared better than the broader market over the course of the last three years, through all the macroeconomic and geopolitical turmoil which we go through at the end of this article.
We are Value Investors!
We often describe ourselves as Value Investors. This sometimes gets people confused because they’re accustomed to self-styled Value Investors avoiding the types of companies that have done so well for our portfolio over the last three years. They are accustomed to seeing value funds buying low quality, low-growth, structurally declining (and often cyclical) businesses, then justifying these decisions based on “cheap valuations”.
We see things differently. We treat “value” as a verb, not a noun. To value a company involves a process of understanding the worth of its future cashflows beyond its present state. To make money doing so involves finding companies where the value we see is significantly greater than the price we have to pay. That is why we focus on high quality businesses with structural growth drivers – as outlined earlier – instead of slow-moving companies trading at low valuation multiples.
In doing so, we are following in the footsteps of the greatest value investors. Warren Buffett, having delegated a portion of his investment responsibilities to younger fund managers, last year defended their decision to buy Amazon, noting that they were “absolutely [as] much value investors as I was when I was looking around for all these things selling below working capital years ago.” Even Benjamin Graham, the father of value investing, concluded in his seminal work, “The Intelligent Investor”, that the majority of his post-World War Two fund returns came from a high quality, high growth insurance company, Geico – a company which Buffett would eventually absorb into Berkshire Hathaway.
How has our approach fared in practice?
Our first three years have been a “baptism-by-fire”, with unprecedented macroeconomic and geopolitical events rocking the investment landscape. In 2018, we had questionable monetary policy from the US Fed and we saw President Trump initiating a trade war on multiple fronts. Trade tensions continued in 2019 while uncertainty from Britain leaving the EU lasted throughout the year. Now in 2020, the global economy is still reeling from the worst global pandemic since the Spanish flu more than a hundred years ago.
Nevertheless, we have managed to deliver positive returns each year with a combination of our in-depth research process and strict valuation discipline. The graphs below show how we fared in 2018, 2019, and in 2020-to-date.
1I class Acc shares, net of fees priced at midday UK time, source: Bloomberg. 2 IA Global Sector average, source: Lipper. Lipper. Performance data for period 11/09/2017 to 31/08/2020.
We have relished the opportunity to test our approach under adverse market conditions and we are glad that we have been able to deliver consistent significant outperformance to our investors during both market rallies and sell-offs. This is what active management is all about, and this is only just the beginning for Blue Whale!
Please note that the information provided in this article is not to be construed as advice and any views we express on holdings do not constitute investment recommendations and must not be viewed as such. If you are unsure as to the suitability of an investment for your circumstances, please seek independent financial advice. Investments can go down in value as well as up so you may get back less than you invested. Your capital is at risk. Past performance is not a guide to future performance.