Our objective is to discover outstanding companies with sustainable, high returns on capital and open-ended growth, then to buy them at a “value” price. Although our investment process is relatively uncommon, it is the same process practiced by all of the portfolio managers at Lateef throughout their careers, and now polished by our collective experience.
We actively monitor a Lateef universe of about 60 companies that have met our quality criteria, and we assess them daily for attractively priced entry points. A company is purchased only after each portfolio manager agrees that the company has met at least two-thirds (or 17) of our 25 investment criteria. Our investment candidates come from a variety of sources, including discussions with company executives about their respected competitors, suppliers, distributors, and customers. They may come from industry periodicals, industry trade shows, Wall Street investment conferences, Wall Street research, and our colleagues in the industry. We also frequently check the new low lists, and we review data-rich publications such as Value Line. We don’t use a “black box”computer to screen for ideas, as our experience has shown this to be a “rearview mirror” method of discovering companies that are often at their cyclical peak. We have mentally screened hundreds of companies in our careers and have ruled out those which have cut throat competition, are heavily regulated, have a principal product subject to commodity pricing, are capital intensive, or have a short product life cycle. In today’s world, where data is only a few clicks away, the challenge is not in obtaining information, but in transforming information into insights and knowledge that meet our criteria.
The heart of our investment process is the initial evaluation and ongoing monitoring process of investments. It is the lifeblood of what we do. The following Pyramid of Growth illustrates the essence of our core criteria. Although we have 25 specific investment criteria, they boil down to finding a company with a sustainable competitive advantage and high return on invested capital (ROIC), led by an owner-oriented management team of high integrity, and a track record of success, whose stock is trading at a reasonable or bargain price.
We rely heavily on our own intensive fundamental research. We visit with the management of the companies in which we invest on their home turf and build relationships with them over the years. We enjoy the “tire kicking” process, and believe the time and effort is worth the reward of a better understanding and deeper conviction in the company and its people. Once managements meet us and realize that we are interested in longer-term strategic and competitive positioning issues, they are often open, responsive and communicative with us. We prefer managements that are accessible, especially when the inevitable rumors or specious analyst downgrades affect the stock price. We need a direct and expedient line of communication to discern truth from misconception to be most effective for our clients.
Our accounts are separately managed and our focus is on absolute returns. Consequently, we will only invest when we believe the company’s market price is attractive compared to its intrinsic value. For new clients, this process may take just a few days – if there are many opportunities in a bear market – or several months, in a bull market. We would rather take our time in making the right choices to limit downside risk than have to apologize later for losses because we responded to an urge to get invested right away. Risk, in our view, is the risk of losing money. We do not define risk as potentially falling behind a bull market benchmark for a few months while the cash is getting invested.
We invest each account individually and do not manage on a “model.” Managing accounts on a model means that every account is fully invested on the first day and holds the same stocks. Lateef does not manage accounts in this way because we feel that it is imperative to not only buy outstanding companies, but it is equally important to buy those companies at the right price. Therefore, we invest accounts one stock at a time, and we will only purchase when a company is trading at or below our buy target price. When a company drops into our buy range, it is added to each portfolio with cash at approximately a 6% weight. Due to this strict purchase criteria, each account under Lateef’s management may not hold all of the same securities, depending on the inception date of each account. While this process creates a higher dispersion between accounts, we think it makes the most investment sense, ultimately resulting in better performance.
The businesses that interest us are those that have a sustainable high return on invested capital (ROIC). With all else being equal, the most valuable businesses are those that deliver more cash flow and income with fewer assets. Return on invested capital is a financial measure that quantifies how much income a business earns relative to the capital contributed by both equity shareholders and lenders. Our composite top 25 holdings have a return on invested capital in excess of 20% – nearly double what the average company earns on capital, and more than double the cost of capital for most companies. For companies with no debt, return on invested capital is simply return on equity, which is defined simply as net income divided by net worth (or equity).
Most investors define a company’s growth rate as the rate at which it increases its earnings per share (EPS). We think this is not only overly simplistic, but sometimes wrong. EPS is a result of many accrual assumptions, which may not correlate to the actual cash generated by the business.
The true growth of a business is measured by its return on capital. For example, a business that is funded with $1,000 on January 1st and earns $200 in cash for the year has a 20% return on its $1,000 original capital. At the end of the first year, it has $1,200 of retained capital, assuming no dividend payouts. If it earns another 20% on its $1,200 retained capital in year two, it will have earned $240, making its capital at the end of year two $1,440. Extending this 20% compounding forward for 3.8 years will result in total capital of $2,000, or double its original investment.
We have observed that over time, a company usually trades at a Price-Earnings ratio (PE) in line with its sustainable return on capital. Assume, for instance, that we invest in a company with a sustainable return on capital of 20%, whose stock is depressed for some temporary, nonstructural reason, and has a PE ratio of 15x. The investment should benefit from a “double play” effect. The stock should benefit from a rebound to its normalized PE of 20 as the cloud overhanging the stock evaporates, and then, the stock should benefit from the compounding of the company’s return on capital, thereby increasing its intrinsic value. We limit price risk by patiently waiting for terrific companies (those with sustainable high ROICs) whose stock prices are temporarily out of favor, offering an opportunity for us to pay a PE at a discount to its intrinsic value along with a “double play” opportunity. Well executed “double plays” in a portfolio of 15–20 investments can contribute significantly to investment performance with minimal business and price risk.
We also measure a company’s return on capital exclusive of any excess cash it may have on its balance sheet, indicating a more robust business profitability. Many of our companies have little or no debt on the balance sheet and have significant cash not needed to run the business.
Our portfolio companies generate excess cash over and above needed capital spending. We use other valuation metrics as a “sanity check”, such as comparing a company’s cash flow yield to the 10 year treasury bond. We also value companies by comparing a company’s PE ratio relative to its historic ROIC for clues to better estimate the intrinsic value of the company. We might also incorporate a sum-of-the-parts analysis to value companies. After estimating the intrinsic value using these methods, we apply at least a 10% discount to the value to derive our “buy point”, there- by enhancing our margin of safety. For example, if we believe a company is fairly priced at $50, we will not buy it until it drops below $45.
We take a practical business approach to investing. This approach applies equally whether we’re valuing a neighborhood lemonade stand, the corner grocery store, or General Electric. We believe we are unique in our emphasis on ROIC and, in particular, in using the ratio of PE to ROIC as a guide to valuing companies. Combining this approach with our due diligence to give us the conviction that a company’s competitive advantage is sustainable, along with the discipline to wait for the right market price, gives us the edge to outperform.
Our bias is not to sell. If we must, we reinvest the proceeds only when it makes sense to do so. There are, however, five conditions under which we feel that selling a stock is necessary:
When a position exceeds 15% of a portfolio. If an investment that typically starts with a 6% weight
appreciates to 15% of the portfolio, we will consider gradually trimming the position for the sake
of prudence.
Overvaluation. If the stock price is egregiously overvalued and discounts earnings excessively into the
future, we will sell. This was key to our success in preserving capital in the years 2000–2002. We are
content to hold a modestly overvalued stock if we are confident that future years’ earnings growth will
justify the valuation.
Deteriorating fundamentals. For each company we buy, we document our rationale for investing in the
company. If subsequent events erode its competitive advantage and violate our original rationale,
we will sell.
When there’s a better idea with more conviction. If we find a much better business that is attractively
priced, we will sell to generate cash for the new purchase.When we recognize a mistake. Despite our
rigorous due diligence process, we do occasionally make mistakes in assessing the management or
competitive dynamics of a company. When this happens, we immediately sell to limit losses and move
on to a better opportunity.
When we recognize a mistake. Despite our rigorous due diligence process, we do occasionally make
mistakes in assessing the management or competitive dynamics of a company. When this happens,
we immediately sell to limit losses and move on to a better opportunity.
