Allen Iverson famously said when dealing with the press questions about him missing practice, "Practice, we talking about Practice, not a game but practice." Well in investment management one thing we don't talk enough about is not practice, but rather process. Yes Allen Iverson, we will be talking about process in this blog, investment process.
Why is talking about process so important, and why don't we talk enough about it? As investment managers we spend most of our time talking about and sharing investment ideas. There are a multitude of websites devoted to the sharing of investment ideas, like FinTwit, Seeking Alpha, Value Investors Club, or Microcap Club. But you could have all of the best investment ideas laid out in front of you and without a solid process you will end up with outcomes that are less than optimal and not repeatable. The reason why process is so important, is because within an investment process you can more easily have outcomes driven towards optimal results. A process allows you to be repetitive.
Investing wisely is akin to constructing a building: it requires a solid foundation (screening for ideas), careful planning (selecting ideas), and meticulous execution (portfolio allocation and trading). This blog post will walk you through our investment process at Deep Sail Capital. The goal of the entire investment process is not just to turn over as many stones as possible, but rather turn over as many good stones as possible. The process is meant to help us optimize our time to efficiently find the best new ideas.
Kill Rule. I have a rule that I can kill a company at any point in the process. Meaning at any point if something goes wrong, I simply stop working on that idea. I collect the reason why I Killed the company if it is at a later stage in the process (step 4 or 5), but don't worry about it early in the process. The quicker you can kill a company, the more time you have to work on the next one.
Industry Filter
As we described in our previous blog posts and on our investment strategy page on our website, at Deep Sail Capital we have a specific list of industries that we focus on that we call our Industry Focus. From the beginning of the investment process we apply a filter on all the companies we will spend time on. This list of industries includes:
● Software
● Financial Services
● Payments
● Gaming
● Internet & eCommerce
● Tobacco and Spirits
● Tower Companies
● Medical Instruments
● Medical Diagnostics
● Specialty Semiconductors
● Serial Acquirers
● Technology - Devices & Instruments
1. Sourcing Potential Ideas
The investment process begins with identifying potential investment opportunities. I call the beginning of process sourcing, rather than screening, because I view sourcing as a wider process of identifying ideas through multiple avenues. Sourcing falls into a few major buckets, 1) Screening 2) Other Investors 3) Industry Evaluation and 4) Serendipity.
Screening is pretty straight forward, but there is a nuance to finding situations that I believe had history worked well that forces us to come at screen from multiple angles. For instance, small companies that turn a profit for the first time can often be undervalued as they trade on a P/S ratio rather than an EV/EBITDA or P/E ratio. We use a few different screening tools to try and find companies in this category and others that we believe might produce strong returns in the next few years.
Other Investors refers to sourcing ideas from other investors that are pitching ideas either through Twitter, on blogs, on VIC or Microcap Club, or via investor conferences. Historically, this area of sourcing has yielded some of the best and worst results. I tend to love this area of sourcing, as I often find many unique ideas with qualitative insights that screening cannot provide. The pitfall of sourcing ideas from other investors is leaning too much on those investors analysis rather than completing your own. Due to the rigorous steps we go through after the sourcing process, we will generally be less selective when sourcing potential ideas.
Industry evaluation is generally a top-down analysis. This process is completed either through a formal deep dive on certain sectors (post here) or informally through research. The idea is to understand an industry and trends within that industry, and then try and determine which companies are best positioned to succeed on the backs of that trend. This is essentially "trend" investing.
Sometimes an investment idea comes from a conversation with an industry insider; sometimes it can come from an observation of my wife's shopping habits. Anything in between I call serendipity.
2. Business Review
The next step is an initial business review. This involves understanding the core aspects of the companies, including:
Products/Services: What does the company offer? We assess the quality, demand, and uniqueness of their products or services. Is their product sticky? Do they have any adjacent markets they can easily enter?
Market Segment: We identify the market the company operates in. Is it a growing market? What is the competitive landscape?
Total Addressable Market (TAM): We assess the potential size of the market the company can capture.
Management Team: We then evaluate the leadership. We look for a strong, experienced, and visionary management team, which can be a significant determinant of a company’s success. We look for honest management that sets out a plan and executes on it.
3. Financial Review
The financial review covers key financial metrics and trends, including:
Margins: We look at gross, operating, and net profit margins. We look at ROIC and ROE very closely. This helps us to determine the quality of the business.
Growth: We evaluate revenue and earnings growth. Consistent growth is a positive indicator of a company’s performance over long periods of time.
Historical Cash Flow Analysis: We review the company's cash flow statements to understand how well it generates cash and its financial health.
Capital Allocation: We analyze how the company allocates its capital. Are they investing wisely in growth opportunities, paying down debt, or returning capital to shareholders? Do they issue shares freely, or have they been conservative and aligned with shareholders?
4. Deep Analytical Review
The deep analytical review is an intensive phase where we scrutinize every aspect of the company. This includes:
Competitive Analysis: We assess the company’s competitive position and barriers to entry in its market.
Operational Efficiency: We evaluate operational processes, supply chain management, and scalability.
Risk factors: We identify and analyze potential risks, including market risks, operational risks, regulatory risks, and financial risks.
Valuation Models: We don't fully model out DCFs, as we view that as a waste of time. Instead, we use various valuation models (3-year IRR based on growth and profitability, EV/EBITDA, Rule of 40) to determine the company’s intrinsic value and compare it with its market value.
5. Buy Decision
Once a company has passed all of the above steps, we make a final buy decision based on the analysis completed and the valuation relative to the other options available in the market. We do this by modeling the IRR over the next three years and then adding it to our portfolio allocation process.
On Going Portfolio Allocation
Our portfolio allocation process is an on going process to attempt to correctly allocate our portfolio to the most attractive approved investments at a given time. We take into account the following on top of our modeled IRR.
Diversification: We avoid putting all your eggs in one basket. We ensure the portfolio is diversified across different sectors and asset classes.
Risk Management: We allocate capital based on our defined risk tolerance, in which our maximum position is 20% of fund NAV. We look to have between 20 and 25 long positions.
Rebalancing: We are constantly rebalancing our portfolio based on our optimal allocation breakdown.
Conclusion
The investment process is a meticulous and systematic journey that, when executed well, can lead to informed and profitable investment decisions. The easiest part of the investment process is creating it; the hardest part is following it all the time. Consistently applying the process and sticking to it is, in the end, how we plan to outperform our benchmarks over the long run. The process has changed a bit over time, and I expect as Deep Sail Capital grows we will continue to refine and adjust our process, but we will always have a process, as it is the only way to have repetitive success.
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