Four Pillars of an Exceptional Investment
Updated: Jan 8
At Deep Sail Capital, we have developed a framework for understanding and evaluating investment opportunities that we call the Four Pillars of an Exceptional Investment. The framework we have developed was influenced by Chuck Akre's "Three Legged Stool" and Thomas Gayner's Four Investment Principles. Both Akre's and Gayner's investment styles align closely with ours at Deep Sail Capital. Both investors take a long-term approach to investing and attempt to own businesses that have large, long-lasting moats that can deliver outsized returns over long periods of time.
There are several other influences that contributed to the development of our Four Pillars of an Exceptional Investment framework, including Chris Mayer's book 100 Baggers Stocks That Return 100-to-1 and How To Find Them and Michael Mauboussin's research around moats, margins, returns on capital, and base rates. Each of these sources of analysis arrived at various conclusions on investing which fall into a few core elements of every business: the business model, management, capital allocation, and potential for growth. Out of each of these core elements, we built our framework for the Four Pillars of an Exceptional Investment to specifically suit our growth investment style. Our Four Pillars are: a high-quality business model, outstanding management, substantial long-term growth prospects, and a reasonable valuation.
High Quality Business Model
As we summarized in our previous blog post, "Why We Invest in Quality," one key factor that contributes to long-term returns is the quality of a business model. Quality refers to the ability of a company to generate sustainable profits over long periods of time. Companies with high-quality business models are able to consistently generate profits over time, even in the face of economic downturns or industry disruptions. This stability is attractive as it provides a level of predictability, confidence in the company's future performance, and the ability to continually generate shareholder value at abnormally high rates.
A high-quality business needs two things to be successful: a wide moat and a profitable model. High moats may include unique intellectual property, regulatory barriers, high switching costs, network effects, and embedded technology. Companies with strong competitive advantages are better positioned to fend off competitors and maintain their market position over the long term. When it comes to moats, we actually don't think moats need to be very wide, but rather they need to be very stable and unchanging over time.
A profitable business model is a requirement for a high-quality business. In order to have a profitable business model, you need to have one that allows you to continually deliver above-average returns on investment over long periods of time. This is often driven by the same sources as a high moat, but there is a subtle difference between the two. Moats prevent competition from entering and eroding profits, whereas a highly profitable model allows you to generate a high ROIC (return on invested capital).
A great management team is a crucial component of a successful company. These individuals are responsible for setting the strategic direction of the company, making key decisions, leading the organization towards its goals, and allocating company capital. When a company has a strong management team in place, it is better positioned to navigate challenges, seize opportunities, and build long-term shareholder value. A great management team is a requirement for an exceptional investment to prevent value-destroying decisions like costly M&A, empire-building, short-term thinking (chasing earnings or window-dressing), or management plundering profits.
Assessing management strengths is often a difficult task, as many management teams may "talk the talk" and sound very convincing but lack execution and decisiveness. We like to access management's track record of executing on what they have promised. We do this by reviewing earnings and investor calls for the past few years to determine if the current management has executed on their recent plans. An exceptional management team should reinforce to investors that they are executing at every earnings call. The more you hear the management team speak, the more comfortable you should become with them. If the opposite is true, you should likely reconsider your investment in the company.
To have an outstanding management team, we believe management needs to have the following traits:
Honest and forthcoming with investors, employees, and counterparties
Deep understanding of their own industry dynamics
Focus on execution, including reviewing previous management plans and guidance and owning the outcomes, be they success or failure.
Great capital allocators that understand their capital allocation options and focus on creating value per share
Substantial long term growth prospects
At Deep Sail Capital, we are long-term investors. We would like to own businesses for many years that have the ability to grow and compound our capital at high rates. The main reason for this is tax efficiency. Paying taxes on short-term capital gains every year is a huge incremental cost that cripples long-term value generation. Over 25 years, a portfolio that generates an 8% annual pretax return but pays short-term capital gains generates only a 5.2% annualized posttax return, while a portfolio that defers taxes until year 25 generates a 7.2% annualized posttax return. That doesn't seem like much of a difference, but over 25 years, the tax-deferred portfolio would generate a 478% total return vs. a 255% total return for the short-term capital tax portfolio. This is the essence of compounding.
So if we need to own companies for long periods of time for tax efficiency reasons, than what types of businesses should we want to own? The clear answer is businesses that can consistently grow for long periods of time. As this wildly overused chart from Morgan Stanley shows, over long periods of time revenue growth is a key driver of stock performance and, in turn, long-term value growth. In the end, we want to own companies that can grow their per-share free cashflows, but often the best way to do this is to grow their revenues through capital-efficient reinvestments in their businesses.
Companies can grow their businesses in several ways: by launching new products, gaining market share, increasing margins, expanding their footprints, or buying other businesses. At Deep Sail Capital, we believe there is not one single best way that a company can generate long-term growth in cash flow per share but many ways.
We have analyzed several models from different industries and found that companies with defined growth strategies that understand their capital allocation process tend to be able to generate higher growth than their peers. We believe that companies with historically high growth rates tend to have a higher ability to grow at high rates into the future. But more than just looking at the growth rates, you need to understand why their business growth rate is higher than their peers' and why it will remain high for many years.
Much of determining which businesses have sustainable long-term growth prospects comes down to understanding industry dynamics, competitive positions, and industry trends. That is why we spend much of our time completing deep dives on certain industries or subindustries. We want to both understand overall industry trajectories and find the best businesses within those industries. We generally like to start by understanding the overall industry growth rates and potential, then dig down into specific companies to understand why they might outpace the overall industry.
Another important aspect that we look for companies with business models that are scalable. Companies with scalable business models are able to grow their operations and revenues while improving their gross and/or operating margins. This allows them to capture a larger share of the market and increase their profitability as they expand.
At Deep Sail Capital, we employ a growth at a reasonable price (GARP) strategy. The reasonable price portion of that is extremely important to long-term gains, as in the end, you're buying the future stream of cash flow from a business. Paying up for high-quality growth companies doesn't mean buying them without any valuation consideration. We take great care in evaluating the long term profit margins and business model potentials when viewing potential investments. We would love to own high-growth, high-return businesses at extremely cheap multiples of earnings, but generally, those investments are either not available or have massive risks associated with them.
Our preferred method of valuing a company is via a DCF model, but we don't spend our days modeling. DCF models are a useful tool to guess at what a business's valuation could be as well as teach you how a business model works. But DCF models have some inherent biases and issues, including forecasting bias, estimating equity risk premiums, and the assumption that markets are efficient. No one has ever found a 10 bagger with a good DCF model.
We do believe that understanding how others model businesses via a DCF model does help you find particular insights especially in high growth companies. Due to the way most investors create a DCF model in which all businesses face slowing growth after year 5 and then terminal growth after year 10, we believe there is a huge opportunity to buy businesses that will outpace growth in the years 5+.
Overall, we want to make sure the valuations we are paying for businesses are reasonable in both a bullish and a bearish scenario. Obviously, the cheaper the better, but when evaluating high-growth, high-quality businesses, you need to look further out than just a few years.
Putting it all together
Using our Four Pillars of an Exceptional Investment framework we believe we can generate a small edge over the overall market. Combining our industry focus and our three areas of focus: quality, microcap, and special situations with our Four Pillars of an Exceptional Investment we believe we can generate strong capital appreciation that can endure over many years.