Thursday, 29 July 2010

****Desired Characteristics for Potential Investment (Investment Philosophy of Magellan Infrastructure Fund)

Magellan Infrastructure Fund - Investment Philosophy

The Magellan Funds have two principal Investment Objectives:

  • to minimise the risk of permanent capital loss; and
  • to achieve superior risk adjusted investment returns over the medium to long-term.

Our Investment Philosophy is simple to state. We aim to find outstanding companies at attractive prices. We consider outstanding companies to be those that have sustainable competitive advantages which translate into returns on capital materially in excess of their cost of capital for a sustained period of time. While we are extremely focused on fundamental business value, we are not typical value investors. Securities that appear undervalued on the basis of a low price to earnings multiple or a price to book multiple will often prove to be poor investments if the underlying business is fundamentally weak and exhibits poor returns on capital. We will buy companies that have both low and higher price to earnings and price to book multiples provided that the business is outstanding and the shares are trading at an appropriate discount to our assessment of intrinsic value.

An outstanding company will usually have some or (ideally) all of the following characteristics:

An economic moat refers to the protection around an economic franchise which enables a company to earn returns materially in excess of the cost of capital for a sustained period of time.

Outstanding companies are unusual as capitalism is very efficient at competing away excess returns, in most cases. A company’s economic moat will usually be a function of some form of sustainable competitive advantage.

A strong indicator as to whether a company possesses an economic moat is the historical returns on capital (both including and excluding intangible assets) it has achieved. If a company has earned returns materially above the cost of its capital for a sustained period, it is a good indication that a company may have an economic moat. In some cases, a company may be developing a strong economic moat, but its historical returns on capital are low reflecting the investment in building a business with long-term sustainable competitive advantages. The key lesson is that historical returns on capital do not necessarily indicate whether a business has a wide economic moat and it is critical to fully understand the competitive advantages and threats which protect and threaten a company’s economic franchise.

Identification of companies with wide economic moats involves consideration and assessment of the barriers to entry, the risks of substitutes, the negotiating power of buyers and suppliers to a company and intensity of rivalry amongst competitors.

The following are illustrations of sustained competitive advantages:

  • Where it is very expensive for consumers to shift from the incumbent provider (that is, where there is a low threat of substitutes) because of, for example, cost, inconvenience and/or regulatory restrictions.
  • Where the leading market participant has material economies of scale which gives it a significant cost advantage over competitors or new entrants.
  • Where the business has a strong and unique brand name or is protected by long-term intellectual property rights such as copyright, patents, trademarks and/or regulatory approvals.
  • Where a company has a very strong network (ideally monopoly or proprietary). For example, where it is the vital intermediary between buyers and sellers, a market maker or even a ring road that tolls workers and businesses use as they move people and goods. We are particularly interested in networks where access, pricing and volume are subject to market forces and are not regulated in a materially adverse manner.
  • Where the use of psychological imperatives (such as, safety, exclusivity and quality) drives customer loyalty and enables companies to charge a premium for their products or services.

Each of these sustained competitive advantages is relatively unusual and it is particularly valuable where a strong competitive advantage prevails over a long period of time. Market-based monopolies and proprietary networks can provide the strongest and most sustainable competitive advantages, but are extraordinarily rare.

We seek companies that have a moderate to high potential to continue to re-invest capital into the business at high incremental returns.

We believe that conventional investment analysis fails to properly assess the potential of a business to deploy material amounts of additional capital into the business at attractive rates of return. This is a fundamental driver of value over time.

The most attractive types of companies are either:

  • Companies with wide economic moats which can continue to grow materially with very limited additional capital.
  • These companies will exhibit rising returns on capital employed. These types of businesses are extraordinarily rare and extremely valuable.
  • Companies with wide economic moats which have opportunities to deploy material amounts of capital into the business at high incremental rates of return. Examples include a strong retail franchise with substantial roll-out opportunity, or a retail banking or financial services franchise that can continue to grow its lending activities at attractive margins.

These types of businesses are rare and can be very valuable compounding machines. It is more usual to find businesses with wide economic moats which can only deploy very modest amounts of capital and exhibit modest growth potential. These businesses, while attractive, are less likely to be compounding machines than those with material high return re-investment opportunities.

We are therefore very focused on assessing a company’s ability to continue to re-invest free cash flow at high rates of return. It is factors such as, store roll out potential, global expansion potential, the size of the market and market share potential, and market growth rates, which will drive this re-investment potential.

We judge re-investment potential as low, medium or high depending on the level of re-investment over the medium term as a percentage of net income, and the rate of return expected to be achieved.

The purpose of assessing business risk is to determine the predictability of cash flow and earnings projections. Businesses which are difficult to predict or could exhibit large variations in cash flows and earnings have high inherent business risk.

We assess business risk taking into account factors such as cyclicality, operating leverage, operating margin, financial leverage, competitive strength, regulatory and political environment and profitability.

We assign each company a risk assessment: low, medium and high. This is not an attempt to measure the volatility of the shares, but rather the predictability and strength of the underlying business.

We term the risk surrounding the deployment of the free cash flow generated by a business as €˜agency risk’.

A fundamental assumption inherent in a standard discounted cash flow valuation (DCF) is that free cash flows are returned to shareholders or are re-invested at the cost of capital. The reality is that this assumption is often flawed as free cash flow is often not returned to shareholders but, rather, cash is re-invested by companies at returns below the cost of capital. In these cases, businesses can end up being worth substantially less than implied by a DCF analysis. We term the risk surrounding the deployment of the free cash flow generated by a business as agency risk.

A company which can deploy a substantial amount of free cash flow back into the business at attractive returns for a sustained period of time will almost certainly carry lower agency risk than a company which has limited opportunities to re-invest capital at attractive returns, unless the company is explicit about returning excess cash flow to shareholders via dividends and/or share buy-backs.

In assessing agency risk, we look at factors, including the structure and level of incentives offered to senior management, the level of share ownership by senior management and directors, the track record of management in pursuing acquisitions, the desire of management to grow their empire and the track record of management and the Board in acting in a shareholder friendly manner, including returning free cash flow to shareholders via share buy-backs and/or dividends.

The assessment criteria we apply in evaluating potential investments are depicted in the diagram here.

An ideal investment will normally have a number of combined favourable attributes operating together which would illustrate what Charlie Munger of Berkshire Hathaway describes as a Lollapalooza effect (which is a term for factors which will reinforce and greatly amplify each other).

We will only purchase an investment when there is a sufficient margin of safety. The margin of safety is the discount we require before buying shares of a company. The bigger the assessed discount, the wider is our margin of safety.

The available margin of safety, we believe, is driven, in part, by prevailing market psychology. While not a driver of a company’s quality or intrinsic value, the markets can have a profound, albeit rarely long-term, effect on the pricing of a company’s shares. When short-term issues or concerns are worrying investors or other factors are resulting in excess enthusiasm (that is, irrational exuberance), shares will often be mis-priced relative to intrinsic value. While our process can make us appear to be out of step with trends, investing contrary to consensus thinking has the potential to provide investment opportunities. Understanding where current market sentiment lies and assessing the company within the context of whether the concern or excitement is being appropriately priced, is an important step in investing.

There are some exceptional businesses where the Lollapalooza effect is truly at work and the moat is so wide and the risks are so low that we will invest with a very modest margin of safety. It is more usual to find companies which do not have all the reinforcing factors at play which results in a higher level of risk and requires a higher margin of safety.

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