Start With a Margin of Safety. End With a Growth Mindset
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The first rule of investing: never lose money blah, blah, blah…
Our team at CCM has officially launched an investment fund called Arch Capital. Our strategy (long-only, concentrated) is not unique, but we hope our communication can be. We strive for transparency and learning in public, which is why we update our holdings on our site each month. I also hope to share various parts of our investment process, which is the subject of this post.
When Ryan and I talk about a potential investment, the last part of the pitch is a discussion on these two questions:
Over the next 3-5 years, what are the chances this investment loses money?
What chance do you give this stock, at current prices, to compound at 15% over the next 3-5 years?
We start with a margin of safety, and end with growth. Here’s why these two questions are important to us, and why they are asked in this specific order.
Starting with a margin of safety
All investors, whether “growth” or “value” (although that distinction is dumb), should start by analyzing the safety of their investments. The quote “first rule of investing: don’t lose money” is a cliche for a reason, because an 80% drawdown or permanent loss of capital can kill your performance. Just ask Melvin Capital.
This is why we always ask the question: Over the next 3-5 years, what are the chances this investment loses money?
However, if we end up thinking there is a significant chance of losing money (say, a 25% chance or greater), it doesn’t mean we won’t invest. It just means we require a higher compound annual growth rate when underwriting the investment.
For example, when we look at a stock like Altria Group, the margin of safety (in our opinion) at the current valuation is extremely high. Compared to a riskier bet like Spotify, we don’t expect an insane CAGR from Altria, simply because of the safety embedded in the business. While no investment is a guarantee, the difference between a 5% and 50% chance of losing money is gargantuan and should affect your required upside.
Next, move on to growth
After discussing downside, Ryan and I move onto the fun stuff: the potential upside of a stock.
We start by asking the question: What chance is there that this stock compounds at a 15% rate over the next five years?
15% may seem like a high hurdle, but our goal at Arch Capital is to compound our partners’ money at better-than-market returns, net of fees. Having a mid-to-high teens hurdle for our investments gives us confidence that, if we are right in our theses, we can achieve this goal.
When deciding whether an investment passes the 15% hurdle, we take into consideration a few factors. First, we look at the financials, focusing on sales and free cash flow (FCF). All that matters to us is what we think sales can grow to and what FCF margin the company will earn on those future sales. Other parts of the income statement matter, and factor into current and future FCF, but are just inputs to what matters in the long-run to stockholders.
Next, we ask, what will the share count be in five years? Is the company heavily diluting shareholders, or is it reducing share count through buybacks? If two businesses generate equivalent amounts of cash flow every year and the market assigns the same multiple on that cash flow, and one business reduces its share count by 2% each year while the other increases its share count by 2%, the one that reduces its share count will compound at a 4% higher rate each year.
Next, we focus on valuation. I like to start with the sales multiple as it allows for flexibility when evaluating future FCF and earnings power. However, the output valuation number we like to stick to is enterprise value to free cash flow, or EV/FCF. Then, we ask ourselves, what multiple will the market assign this FCF in five years?
All this analysis comes down to what FCF/share we think the company will generate in five years, and what multiple the market will deem this FCF is worth.
This process does not involve groundbreaking or proprietary research, which is entirely the point. Professional investors have a tendency (in our opinion) to put their focus on things that don’t matter. Most of the time, the macro environment, currency fluctuations, politics, inflation, and a myriad of other things the financial media focus on are worthless inputs to your investment thesis. Or, if they do matter, it is impossible (and therefore futile) to predict how they will impact a stock you own.
Keep it simple, have common sense, and employ a long-term mindset. That’s all we are trying to do with our investments.
In early 2021, a lot of investors seem to be ignoring the margin of safety, putting all their focus on the growth potential of the businesses they own. “But look, this thing has grown sales at 50% over the last few years and has a giant TAM.” Yes, sure, but what valuation is it trading at? How confident are you this sales growth can continue and be leveraged into future FCF? What has the share count done over the past few years? If it has grown at 5% a year, is it reasonable that dilution will continue in the future? These are all questions you should be asking before putting your money to work.
Disclosure: The author is not a financial advisor. Ryan Henderson and Brett Schafer are general partners at Arch Capital. Clients of Arch Capital own shares of Spotify and Altria Group and may own any other securities discussed in this post.