Australian Equity Small Cap IMA
Investment Philosophy
The TAMIM Australian Equity Small Cap IMA's investment philosophy can be summarised as concentrated value-style. The investment approach is based around the fact that some businesses are inherently better than others.
TAMIM's objective in this individually managed account (IMA) is to invest in businesses which are trading at a large discount to their risk adjusted true worth. We seek businesses where the difference between the share price and assessed value (intrinsic value) is sufficiently large to afford an appropriate margin of safety to justify the investment and to maximise the chance of long term outperformance. To achieve this, we draw from the insights of two bodies of knowledge: value investing and behavioural finance.
We consider that both approaches are complementary aspects on the same theme – the exploitation of inefficiencies in human thinking and market behaviour.
The TAMIM Australian Equity Small Cap IMA's investment philosophy can be summarised as concentrated value-style. The investment approach is based around the fact that some businesses are inherently better than others.
TAMIM's objective in this individually managed account (IMA) is to invest in businesses which are trading at a large discount to their risk adjusted true worth. We seek businesses where the difference between the share price and assessed value (intrinsic value) is sufficiently large to afford an appropriate margin of safety to justify the investment and to maximise the chance of long term outperformance. To achieve this, we draw from the insights of two bodies of knowledge: value investing and behavioural finance.
We consider that both approaches are complementary aspects on the same theme – the exploitation of inefficiencies in human thinking and market behaviour.
Investment Process
Our starting point as a value investor is that all companies have an underlying, true, value – its intrinsic value. Although this value cannot be directly observed, with skilled analysis and diligent research, an estimate may be made. This intrinsic value is then compared to the market price, and if the difference between the two is sufficiently attractive an investment will be made.
Looking at several aspects of this investment approach:
The approach to asset selection has four distinct phases: initial screening, intermediate screening, modelling and management meeting, and finally monitoring and investment.
1) Initial screening
After consulting a wide range of sources, once a company is identified as potentially interesting the first step is to decide whether the company is within our circle of competence.
Having done that, the next step is to do some basic screening on the main financial metrics of the business. The initial screen is based on the most recent reported results and the results used are adjusted for asset purchases or sales, exceptional items, unusual tax charges, etc.
This initial screening enables a quick analysis which will eliminate companies which are loss making, have strange return characteristics, low ROE’s or PE’s which are astronomical. The purpose of the screen is to screen out not screen in. As such some good companies might be rejected but lots of bad companies are likely to be eliminated. From this screening we use the team’s judgement and experience to decide which companies get through to the intermediate valuation.
2) Intermediate screening
The intermediate stage uses a more considered estimate of earnings and valuation of aspects of the business which have no earnings (such as surplus land) or minimal earnings (such as share portfolios). Other factors also considered at this stage include the structure of the balance sheet, management compensation, dilutionary impact of share issues, and items from the balance sheet which should be separately valued.
This analysis produces an estimate of the intrinsic value of the business under a range of growth assumptions as well as tests for the quality of the businesses, governance structures, balance sheet and indebtedness ratios, bankruptcy risk, and return characteristics.
A further judgement is then made on these outcomes. The most attractive businesses will generally have high returns, little or no debt, trustworthy and competent management and have a relatively simple business with predictable cash flows.
3) Modelling and Management Meeting
The small number of companies that get through this screen (about 10%) are then thoroughly analysed. This includes a detailed review of historic earnings and company announcements, a full model of the business (including of each of the group’s divisions, balance sheet, income statement, cash flow statement, share numbers and dividends) for at least four years out, a desk review of the industry (competitors, markets, regulators, suppliers, customers, litigation), and a review of any corporate gossip.
Once all of this knowledge is incorporated into the model, a further estimate of the intrinsic value is undertaken. If the business is still attractive we arrange a meeting with the company.
After our desk research and management meeting we assess the firm’s competitive advantage. This will probably involve further research and meetings considering competitors, suppliers, customers, regulators, meetings with former employees, academics and industry experts, and regulators. The purpose of these meetings is to assess the firm’s competitive advantages and the risks to the business model.
We believe competitive advantage stems from five sources:
Network effects - This occurs where the value of the product increases as more people have or use the product.
Cost advantages - This includes scale in distribution or manufacturing and will also include companies whose costs are structurally lower than competitors.
Intangible assets - This will include factors such as brands, patents, licences and government concessions, and even corporate culture.
Switching costs - For instance it is difficult and time consuming to change the bank or telephone company you use. In the corporate environment it can be expensive and risky to relocate plant and equipment or transition from one IT system to another.
Scale efficiencies - This would include natural monopolies, niche markets, and rational oligopolies.
An important factor that tends to indicate that competitive advantage is the return on equity being greater than the cost of equity.
Generally, the expected duration of the competitive advantage will be more important than the size of the competitive advantage.
Having identified the source of competitive advantage we then look to understand how sustainable it is and whether it is becoming greater or being eroded. Generally we assume that economic theory works and competitive advantage will erode with time – our key assessment will be how rapidly this is likely to occur.
4) Monitoring and Investment
It is only after all of these steps have been undertaken, that an investment decision is made. For an investment to be made there needs to be a sufficiently large gap between the assessed intrinsic value and the share price to justify the investment. This margin of safety will vary depending on the reliability of the forecasts (some things are just easier to forecast accurately than others) and the expected time frame before the gap is expected to close.
In most cases no investment will be made and instead the share will be monitored for share price fluctuations, with the investment being made only when the margin of safety is sufficiently wide.
Shares will be sold from the portfolio when the margin of safety between the assessed value and the share price becomes too narrow or a new investment is identified which is so attractive that it justifies exit.
Our starting point as a value investor is that all companies have an underlying, true, value – its intrinsic value. Although this value cannot be directly observed, with skilled analysis and diligent research, an estimate may be made. This intrinsic value is then compared to the market price, and if the difference between the two is sufficiently attractive an investment will be made.
Looking at several aspects of this investment approach:
- We will only make investments where we believe we have a thorough understanding of the business and industry.
- We will only make investments where we think there is a sufficiently large gap between the estimated intrinsic value and the share price of the investment is wide enough to compensate us for the uncertainty in our estimation of the intrinsic value. Some valuations will have greater uncertainty in them than others. Where the intrinsic value is more uncertain a greater discount to the share price is required to make the investment attractive.
- The intrinsic value will not be discovered by looking at the share price or relative value measures such as PE (or EV/EBIT or EV/EBITDA). In the long run, a stock has no life of its own; it is only an exchangeable piece of an underlying business. If that business becomes more profitable over the long term, it will become more valuable, and the price of its stock will go up in turn.
The approach to asset selection has four distinct phases: initial screening, intermediate screening, modelling and management meeting, and finally monitoring and investment.
1) Initial screening
After consulting a wide range of sources, once a company is identified as potentially interesting the first step is to decide whether the company is within our circle of competence.
Having done that, the next step is to do some basic screening on the main financial metrics of the business. The initial screen is based on the most recent reported results and the results used are adjusted for asset purchases or sales, exceptional items, unusual tax charges, etc.
This initial screening enables a quick analysis which will eliminate companies which are loss making, have strange return characteristics, low ROE’s or PE’s which are astronomical. The purpose of the screen is to screen out not screen in. As such some good companies might be rejected but lots of bad companies are likely to be eliminated. From this screening we use the team’s judgement and experience to decide which companies get through to the intermediate valuation.
2) Intermediate screening
The intermediate stage uses a more considered estimate of earnings and valuation of aspects of the business which have no earnings (such as surplus land) or minimal earnings (such as share portfolios). Other factors also considered at this stage include the structure of the balance sheet, management compensation, dilutionary impact of share issues, and items from the balance sheet which should be separately valued.
This analysis produces an estimate of the intrinsic value of the business under a range of growth assumptions as well as tests for the quality of the businesses, governance structures, balance sheet and indebtedness ratios, bankruptcy risk, and return characteristics.
A further judgement is then made on these outcomes. The most attractive businesses will generally have high returns, little or no debt, trustworthy and competent management and have a relatively simple business with predictable cash flows.
3) Modelling and Management Meeting
The small number of companies that get through this screen (about 10%) are then thoroughly analysed. This includes a detailed review of historic earnings and company announcements, a full model of the business (including of each of the group’s divisions, balance sheet, income statement, cash flow statement, share numbers and dividends) for at least four years out, a desk review of the industry (competitors, markets, regulators, suppliers, customers, litigation), and a review of any corporate gossip.
Once all of this knowledge is incorporated into the model, a further estimate of the intrinsic value is undertaken. If the business is still attractive we arrange a meeting with the company.
After our desk research and management meeting we assess the firm’s competitive advantage. This will probably involve further research and meetings considering competitors, suppliers, customers, regulators, meetings with former employees, academics and industry experts, and regulators. The purpose of these meetings is to assess the firm’s competitive advantages and the risks to the business model.
We believe competitive advantage stems from five sources:
Network effects - This occurs where the value of the product increases as more people have or use the product.
Cost advantages - This includes scale in distribution or manufacturing and will also include companies whose costs are structurally lower than competitors.
Intangible assets - This will include factors such as brands, patents, licences and government concessions, and even corporate culture.
Switching costs - For instance it is difficult and time consuming to change the bank or telephone company you use. In the corporate environment it can be expensive and risky to relocate plant and equipment or transition from one IT system to another.
Scale efficiencies - This would include natural monopolies, niche markets, and rational oligopolies.
An important factor that tends to indicate that competitive advantage is the return on equity being greater than the cost of equity.
Generally, the expected duration of the competitive advantage will be more important than the size of the competitive advantage.
Having identified the source of competitive advantage we then look to understand how sustainable it is and whether it is becoming greater or being eroded. Generally we assume that economic theory works and competitive advantage will erode with time – our key assessment will be how rapidly this is likely to occur.
4) Monitoring and Investment
It is only after all of these steps have been undertaken, that an investment decision is made. For an investment to be made there needs to be a sufficiently large gap between the assessed intrinsic value and the share price to justify the investment. This margin of safety will vary depending on the reliability of the forecasts (some things are just easier to forecast accurately than others) and the expected time frame before the gap is expected to close.
In most cases no investment will be made and instead the share will be monitored for share price fluctuations, with the investment being made only when the margin of safety is sufficiently wide.
Shares will be sold from the portfolio when the margin of safety between the assessed value and the share price becomes too narrow or a new investment is identified which is so attractive that it justifies exit.
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