We are value investors who emphasise the quality of the businesses we invest in.
Our investment philosophy is guided by our principled approach and explains what we aim to do for our clients. Simply put, we look to buy good quality assets cheaply.
Remarkably, this sensible philosophy often means investing in a contrarian fashion. We follow our convictions rather than the herd. It is exactly when everyone agrees on the investment merits of a specific asset that they are most likely to be wrong – and the investment risk of the asset is at its highest.
When looking for cheap assets, we make an important distinction between price and value. “Value” is what we calculate an asset to be worth; “price” is what the market is prepared to pay for it. Sometimes they are the same, often they are not. When price is substantially below value, we become interested.
When a low price is associated with a good quality asset, we are even more interested. By quality, we mean the ability of a company to withstand competitive pressures as well as its ability to increase its intrinsic value over time.
These attributes of a good investment - quality and cheapness - help us reduce the chances of our clients suffering a permanent loss of capital. A cheap asset has a large margin of safety to cater for the possibility of our analysis being wrong; and a good quality business can grow its intrinsic value over time, thus protecting investors.
Risk management lies at the heart of our activities
Our investment process explains how we implement our investment philosophy for our clients. A good process does not guarantee a good outcome for each single investment decision. But if we apply a sensible process to a sound philosophy consistently over time we can expect to generate a good overall outcome. In this way, we manage the central risk of investing, which we define as a permanent loss of capital.
Our investment process has the following characteristics
Valuation plays a central role in what we do. We spend a lot of time understanding the economics of the businesses we invest in. This is the only way that we can determine what their intrinsic value is.
We value assets on a bottom up basis. We do not buy into specific geographies, nor do we follow themes or narratives. We do not do any economic forecasting because we feel we have no competitive edge in this area. But then, neither do economists.
Once we decide to purchase an asset our position sizes are determined by their investment risk – not by their proportionate representation in any index.
We follow our conviction and trust our process, regardless of what the rest of the market is doing. If you do exactly the same thing as everyone else the outcome will at best, be average. We are paid to deliver superior real returns over the long term.
The forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact.
The first step to growing capital is to protect it
Long-term real returns are earned by consistently compounding shorter-term gains and avoiding big losses. At RECM we don’t view risk as volatility but rather the permanent loss of capital. The best way to protect capital is to look for a significant margin of safety between the price we pay and our estimate of the intrinsic value of the security. We also focus on buying the securities of good quality businesses. Once we are happy that the business is trading at a sufficient margin of safety, and stands up to our internal due diligence, we assess the business cycle and the popularity of the business. We use these two criteria to determine the size of the position based on how risky the security is, rather than how cheap it is.
Business cycle and popularity are useful risk measures
Working from the assumption that the stock is priced at a significant margin of safety, this process results in a larger position size when the business is more unpopular and experiencing a weak point in its business cycle. The more popular the stock and the higher the point in the relevant business cycle, the smaller the position size. This is significant. What we are doing is adjusting our position size to the riskiness of the investment. Risk is highest when it is least expected, such as when a stock is very popular, and when earnings are strong due to cyclical effects.
Risk is inversely correlated to comfort
Most investors are very comfortable owning a stock when things are going well, and everyone else owns the stock too. So, our process forces us to do what does not come naturally and feels counterintuitive: downsize in the face of comfort, and upsize in the face of discomfort. All else being equal, good returns are likely when assets that are priced for disaster recover, and poor returns are likely when assets that are priced for prosperity disappoint. Our work on popularity and cyclicality helps us to allocate capital not in accordance with what is easy or comfortable to do, but rather with what is likely to generate good risk-adjusted returns.