How do you find companies that you think are worth investing in?
We have no standard way of identifying prospective investment ideas. The only common factor in our search is fervent curiosity, which drives us to read voraciously, engage actively with management teams and industry experts, and run down the leads and ideas that result.
What process do you use to discern these opportunities?
The “three-legged stool” – business, management, reinvestment – describes our research process for identifying those businesses we call compounding machines. It’s an easy process to describe. What’s difficult to convey is how discriminating the process is. True compounding machine businesses are extremely rare. Still rarer are opportunities to buy them at attractive prices.
I think of our research process as one of constantly building and refining our sense of discrimination. For example, I spend four days every year at two wireless infrastructure conferences questioning and interacting with infrastructure companies and wireless carriers from around the world, both public and private. The insights gleaned into business models, management teams, and nuances of reinvestment have proved very valuable to our public company investments in American Tower and SBA Communications. In addition, the contacts and relationships we’ve built at these industry gatherings have yielded opportunities to make compelling private company investments through our private investment funds.
How do you ensure that each opportunity follows your investment philosophy?
Through ongoing assessment of a company’s business model, management, and reinvestment acumen and opportunity – i.e. the three legs of the stool. This question raises the topic of our sell discipline. Some of our investors are initially surprised to learn that we do not set stock price targets at which we would exit or reduce a position. The reason for this is simple: it’s antithetical to compounding. Obvious reasons for this include tax and transaction costs, but those are minor compared to our belief that true compounding machines are rare and not a commodity to be easily replaced like-for-like. We concentrate capital in what we consider exceptional businesses at attractive starting valuations. We fully expect these outstanding businesses to periodically become more richly valued. We have no interest in adding to our holdings at such times but neither are we tempted to sell unless accompanied by a negative reassessment of the business, management, or reinvestment.
How do you manage risk?
Risk is defined differently by different investors. We do not define risk using terms like “volatility”, “beta”, or “tracking error”, all of which stem from the convenient but arbitrary fact that publicly traded equities have constantly changing price quotations daily. Instead, we think of risk in public equities no differently than if we were making investments in private companies. Sound familiar? The three-legged-stool research process for identifying opportunities is simultaneously our first and most important layer of risk management. This is because companies that pass this discriminating filter tend to have well above-average competitive advantages, returns on capital, free cash generation, growth potential, management, and balance sheet strength. In other words, along the dimensions that matter to a private business owner, our businesses tend to have below average risk by being inherently above average.
The second level of risk management centers on our valuation discipline. Simply put, we strive to purchase these businesses at attractive-to-reasonable valuations relative to the nature of the underlying business, its competitive advantages, and the prospective compound annual growth rate in economic value per share. As it relates to our efforts here, volatility becomes far more synonymous with opportunity than risk.
The last component of our risk management strategy is our willingness to let cash accumulate when valuations of prospective and existing names in the portfolio are above what we consider reasonable. In fact, I would point to the healthy cash weighting often found in our portfolios as the most empirical evidence of having delivered on our oft-stated goal: compounding our investors’ capital at above average rates while incurring below average levels of risk.
The good news for folks who speak the language of risk differently than we do is that our approach happens to translate favorably into the metrics that are important to you. Just know that we do not consider those metrics either as an input or output of our portfolio and risk management approach.