Specialising in Equity Only
First Avenue focuses purely in long only equities as a specialist manager. Research has shown that, over long periods of time, equities are the best vehicle for wealth creation relative to all other asset classes regardless of geography. The reason for this is that equities represent ownership in companies that drive economic growth and development over time. It is the only option that protects savings from erosion of purchasing power (enabled inflation beating returns) over the long term.
Limiting our Universe to High Quality Companies
Within equities, our research shows that investing in high quality companies generates superior outcomes compared to any other strategy. This is because high quality companies are able to produce persistently high and stable profits independent of market conditions by controlling ‘fundamental risk’. As the returns earned by equity holders are ultimately driven by corporate profits, this results in superior stock returns with lower ‘price risk’ or volatility. Modern corporate finance theory would expect investors to receive higher rates of return on investment for bearing greater risk. With this view of the world, high quality companies appear to be an anomaly delivering higher returns with lower risk. This phenomenon is better explained by superinvestors such as Warren Buffet. These investors, instead, study the economic moat (competitive advantage) of a company and its ability to protect profitability from competitive pressures.
HIGH QUALITY STOCKS
- Persistent above market profitability
- Existence of a moat to protect against competitive pressures
- Superior returns through organic growth, dividends, and buybacks
- Lower probability of dilution, non-accretive acquisitive growth and bankruptcy
- Lower fundamental risk results in lower price volatility
- Higher cash-flows eventually passed through to investors
- Greater resilience during a period of extreme economic stress
- Nulifies the need to insure portfolio through derivitives
Explaining Future Company Profits Through Economic Moats
High quality companies possess sustainable competitive advantages that allow them to dominate the profit pool of an industry and earn returns above their cost of capital for extended periods. This may be through an oligopolistic industry structure, high switching costs, intangibles (brands and IP), network effect, structural cost advantages or minimum efficient scale (see below). These advantages or economic moats enable a company remain resilient throughout the entire economic cycle by leveraging unique attributes such as superior pricing power or cost control. Our research shows that this universe of companies has a high propensity to outperform the market and also offers greater downside protection during periods of distress.
Controlling our Risk Budget to Achieve High ‘Through-the-Cycle’ Returns
By restricting our universe to high quality companies only, our portfolio is inherently of lower fundamental risk. Our view is that risk (not valuation) is a continuum from low to extreme risk. As one moves up the continuum, the investment philosophy also shifts from a probabilistic exercise to pure speculation highly reliant on timing. Instead of trying to predict the turn of the economic cycle or movements in commodity prices and exchange rates, we study the sustainability of a company’s economic moat to arrive at an intrinsic value. In our world, the greatest risk is a loss of quality and earnings power through economic changes and deterioration of management as put forward by Benjamin Graham. We therefore aim for consistently high returns through the entire economic cycle. With consistency, our portfolio are able to benefit from the phenomenon called COMPOUNDING which was described by Albert Einstein as the ‘greatest mathematical discovery of all time’.