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Pessimism pays

24 January 2017

Insisting on strong corporate fundamentals and focusing on risk factors are crucial to successful investment analysis, according to Tye Bousada of EdgePoint Wealth Management in Toronto.

For the best long-term investors, the biggest roadblock to buying a stock is their own investment process.

Whether it’s understanding a company’s management or knowing its strength within its sector, Tye Bousada of EdgePoint employs an onerous vetting process before making a call – companies have to be exceptionally strong, and exceptionally well-priced, to pass muster.

“I want to follow the business not for a day or a week or a month or a quarter; usually I want to follow it for years before committing the capital,” says Bousada. “I want to see lots of growth. I want to see defendable barriers to entry that are going to protect margins. I want to see good management and, by the way, I want all those awesome things without paying for them. I want to buy it at a discount to what it’s truly worth.”

Stock investors love a good corporate story but, for Bousada and his team, confidence in a company is primarily reached through subjecting it to a series of probing questions and tests. At the heart of this is a preoccupation with risk factors –with what might go wrong.

“We look at real-world risks to businesses,” says Bousada. “We look at risks to revenue growth, the risk of margin contraction, of defendable barriers to entry coming down, of management succession.”

Bousada calculates that he and his partners have managed some $20–30 billion across his different mandates over the past 20 years. Yet in all that time and across all their mandates, he says, they never owned the headline casualties of the global financial crisis – companies like Lehman Brothers, Bear Stearns, Fannie Mae, Freddie Mac, Enron and WorldCom.

“Were we smart enough to know that those businesses were going to go to zero? Absolutely not,” says Bousada. “When Enron got cut in half, I remember opening up the annual report and reading it – I thought there might be an opportunity. And you start reading it and quickly realise you don’t have the first clue as to what’s going on inside that business – so you shut the annual report and move on.”

Turning positive

After risks have been properly assessed, the second focus of EdgePoint’s investment process is growth: finding companies that are going to be materially bigger in the future than they are today, irrespective of what happens in the economy, and ensuring you are not paying for that growth.

“The first part is a lot easier than the second,” says Bousada. “The trick is culling the list of businesses that are likely to grow down to the ones where you are not being asked to pay for that growth.”

One company Bousada found that met his criteria was Aena, which effectively owns all airports and heliports in Spain.

“It’s the closest thing to a monopoly we’ve ever owned,” says Bousada. “The opportunity came two or three years ago when the Spanish government ran into budget issues and had to raise some money – so they sold it. We found it about nine months after the IPO. Until the financial crisis, the airport network in Spain had undergone an enormous construction boom – often they were built to meet double the existing demand.”

The government chose to sell Aena, but investors worried about potential traffic demand because the economy had slowed down.

“We saw a network that had been massively overbuilt,” says Bousada. “[But] we also saw the ability to buy future growth and not pay for it. When 50% of Barcelona and Madrid airports are unoccupied, you’re still heating or cooling the whole airport, staffing a lot of it, and paying for the insurance.”

But that extra slack in floor space (not to mention running costs) also means that, when expansion comes, it doesn’t require much extra investment.

“It’s practically 100% pure profit,” says Bousada. “When we bought it, it was trading at 11 times earnings – not that unusual for infrastructure businesses, because you have to reinvest a lot of your cash flow in order to sustain the existing levels of earnings. In Aena’s case, however, they just gold-plated everything, so they’re probably good for another 20 years. And the growth came faster than we thought – last year it grew at around 11%.”

EdgePoint Wealth Management is a fund manager for St. James’s Place.

 

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. Past performance is not indicative of future performance. Fund values fluctuate and can fall as well as rise. You may get back less than you invested. 

The opinions expressed are those of EdgePoint, and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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