How to make money by investing in "compounders"

By Larissa Fernand |  28-05-15 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

Sean Riskowitz runs a hedge fund in New York with a twist: he only invests in stocks listed on the Johannesburg stock exchange.

Last year, Riskowitz Value Fund returned 23.4% net to investors, after fees and expenses. Over the same time period, the S&P 500 returned 13.7% (including dividends) and the Johannesburg All Share Index returned –2.7% (in dollars). This is on the heels of a spectacular 2013 (50.5%), 2012 (34%) and 2011 (68%).

Here he discusses his investing philosophy.

You often talk of buying “compounders”. Can you explain that?

Over the years, I have evolved as a value investor and have eventually realised that the best investments are companies we call "compounders".

Let me explain. I attempt to profit from the mispricing of a stock, where that company has a significant opportunity to cement its position and grow its intrinsic value at a high rate over the long term. I call such companies “compounders”.

A good company has high returns on invested capital. But the best companies to own are those that have high returns on incremental capital; companies that can continue to invest at a high rate of return in the future. This high rate of return is usually a function of something unique about the business model, usually called the competitive advantage.

So I look for companies with durable competitive advantages because they tend to produce high returns on invested capital.

So “compounders” are companies with a sustainable competitive advantage of some sort that allows them to compound intrinsic value at high rates over the long-term.

Does that mean you ignore the other formulae?

I focus exclusively on buying compounders and have moved away from focusing only on "pure" value investing metrics such as the low PE and low PB.

This does not mean I don't pay the same attention to the margin of safety concept - if anything I think our margin of safety has increased because I am buying companies with which it is very difficult to compete.

I believe this ability to evolve is an important one, so long as you can retain your discipline. Investors sooner or later realise improvements to their strategies, but I think the biggest improvement one can make as a value investor is to recognise that buying great companies at good prices over the long-term is the best value strategy out there.

How do you know a stock is an investment you want to hold?

When I look at a stock, I approach it as if I am going to buy the whole company.

The key metric I generally look for is whether or not a company has high returns on invested capital. If this is the case, you have a good company.

But the best companies to own are those that have high returns on marginal capital: in other words, companies that can continue to invest at a high rate of return in the future. Just like I explained earlier - the competitive advantage.

So you can invert the question and look for companies with durable competitive advantages. These companies tend to produce high returns on invested capital. I tend to look for companies that have this high return characteristic, but also have a good jockey and a long runway.

What I mean by that is that I like to get to know the management of a company and understand its incentives. Usually I invest in companies where management is the founder or significant shareholder in the company. And I look for companies that have a long runway - for example companies operating in markets where there is significant growth opportunity.

So I look for easy to understand but difficult to compete with companies, earning high rates of return on invested capital (now and in the future), which have a long runway and visibility of what the company might look like in 10 years.

And price?

Of course, I always look for the right price: in investing you make money when you buy, not when you sell. There are plenty of great companies available in the world that turn out to be not so great investments because the price paid was too high.

When do you decide when to sell the stock?

Usually in one of three scenarios.

The first would be if I realised I was wrong in some way. This could be because my research was wrong, or my assessment of management was wrong, or the durability of the competitive advantage proved to be incorrect. As soon as I recognise a mistake like this --and we are always trying to recognise these mistakes—I would probably sell the position.

The second is if there is a material change to the competitive positioning of the business. For example, this could be where a company has some sort of regional monopoly advantage which through legislation is annulled, or where a certain barrier to entry relaxes in some form or another, making it easier for competitors to compete. The results of this would be inferior economics to our company and would call for a careful assessment of the situation to see whether or not to sell.

The third instance is if a better company, at a better price, with a resultant better return profile came along. In investing, markets move through cycles, and opportunity is always just around the corner. One needs to be able to sacrifice one's best loved ideas if a better one comes along.

Outside these rules, I generally tend to hold to investments once bought, because I get to compound investors' money along with the companies that are compounding their intrinsic value.

To read more about Sean Riskowitz's investing style and how he has managed to turn out such spectacular returns consistently, read Betting with deep conviction

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