Investors can be complicated. The complication du jour seems to be the contrast between markets that have turned in good results and the concern that these good results will not be able to be sustained—almost too much of a good thing.
In our approach, we seek to distinguish between lightweight, short-term advances that turn out to be unsustainable (mostly derived from a spike in valuation) and heavyweight long-term advances that compound over years and years. The two almost always coexist simultaneously. So, how do you focus on the enduring type and avoid the risks embedded in the tactical variety?
We think that some basic rules can help:
- Top-down is very difficult, bottom-up is only just difficult.
- The goal is not short-term and tactical but long-term and strategic.
- Take a holistic approach that takes both offense and defense into account.
Top-Down and Bottom-Up
Top-down extrapolates from the general to the specific. For example, with an aging population, buy healthcare stocks. Artificial Intelligence will be huge, so pay any price for any company in the space. Or the Democratic candidate means X for the market, and the Republican candidate means Y for the market.
Bottom-up focuses on an individual business and its distinctive business model. In our work, we have the conviction that companies with great balance sheets, lower capital expenditure requirements, high returns on capital, and higher margins represent a greater opportunity set than companies that compare unfavorably on these measures. Our argument is not so simplistic as to say that all companies that fit this profile will turn in superior results, but we do advocate that fishing in these waters will be more successful. Having conviction about quality is the starting point of our investment discipline.
Tactical and Strategic
Tactical investing is seeking to trade for short-term gains. It is usually highly influenced by price momentum and is not picky about why. By our definition, strategic investing involves thinking like a business investor and not a stock trader. It is thinking critically about sustainable competitive advantage and compounding over the years.
Offense, Defense, and Risk Management
The first level of managing risk is a customized asset allocation that fits your needs and tolerances. For equity investors, a discipline focused on quality provides for both offense and defense. This can provide both competitive results in market advances and better protection in market declines (particularly the emphasis on the balance sheet). Having a valuation discipline regarding reasonable price is, in our view, indispensable in managing risk. The market has a narrative about risk trends towards all-or-none and market timing: jumping in and out of being invested. We think of that approach as more difficult and higher risk.
Our goal is not to trade what’s hot for short-term gain or to jump in and out based on momentum or sentiment.
Our goal is to select superior businesses with competitive advantages and realize the advantages that accrue to top-quality companies. To do this, we need not read the top-down tea leaves. We must focus on our proprietary research and continue to distill for the better of the better. The best of the best is a moving target and can make the perfect enemy of the good. We remain confident that we can continue to make this work for you in our portfolios.
