The Extraordinary Investing equation

I have given a lot of thought as to how to describe our style of investing. I managed to break it down into a symbolic equation.

There are five aspects to this symbolic equation, the first three are company characteristics, but the last two are investors characteristics. Let’s break each one down.

Quality Companies

Broadly speaking there are three kinds of companies, those that create value while you own them, those that are value neutral and those that destroy value.

As Extraordinary Investors, we want to own high-quality companies that create value. We want these so that we can benefit from their special characteristics over long periods of time.

As an aside, value neutral companies not your enemy – they deliver commensurate return for the risk. But value destroying companies are a no-no for us.

Growth Prospects

A company has to have growth prospects. In the long-term a company has to grow revenue, which then leads to growing profits, which then leads to growing free cash flows, which then leads to growth in the value of the shares.

The graph below is based on BCG’s analysis of the drivers of shareholder return. It confirms our intuition - in the long-run, revenue growth drives most of the shareholder return.

Beware, it is possible for a company to increase profit and free cash flow, while revenue is stagnant. This can be done by cost cutting and optimisation. But you can’t do this forever, at some point management will run out of costs to cut.

Shareholder Orientation

Shareholder orientation refers to the behavior of management. Most managers are senior employees and as such they behave like employees. They spend their time and effort at work and want to maximise their compensation. I am sure you will agree with them. Why else work if not to earn the highest possible compensation?

I propose to you that while this is logical, it is a suboptimal conclusion.

The most valuable person in any work environment is the one who gives the most. At work, these people are the "golden goose". They create value, so much so that the shareholders are willing to shower them with wealth to keep them.

They create value first and are rewarded handsomely second. Their outcome is self-enrichment, but their personal goal is to enrich others. This is one of life’s paradoxes – if you want to be rich, make it your goal to make others rich.

Don’t believe me?

Here is what billionaire investor Christo Wiese thinks.

Wiese was Chairman and the largest shareholder of Shoprite, the South African retailer. The group has been operated and grown for decades by CEO Whitey Basson. In 2011, Basson received a pay package of ZAR 627 million (approximately $90 million at the time). This was a high pay package and got a lot of media attention.

When Shoprite Chairman Christo Wiese was asked about it, he described Whitey Basson as a rare talent and said “If I could find another Whitey Basson, I would happily pay him a billion”.

In our quest to be Extraordinary Investors, we need to find management teams who have a shareholder orientation. Their goal must be to create value for us, not to extract it for themselves. Eventually, they will be remunerated very well.

Investor Mindset

Until now, we have looked at company characteristics. Investor mindset is the first of our characteristics (as investors) that must be in place to achieve long-term wealth creation.

Our preferred mindset is that of the owners of a family business.

Families are not concerned about the value of their business, they are concerned with running it well. They don’t see it as something to sell to get a windfall, but rather something that can continue on forever.

That means families have the ultimate long-term orientation. This is the secret of investing – compound your money over long periods of time. I described why compounding is so powerful in a previous newsletter, available here. 

But let’s look at the evidence. Morningstar conducts a study which shows difference between the return investors achieve and the returns that funds achieve. The study shows that investors in funds don’t manage to achieve the fund’s return.

Morningstar found that for the 10 years ended 31 December 2022, the average dollar invested earned a return of 6% per annum, while the average fund earned 7.7% per annum. Investors lost out on 22% of the return that was available to them.

How is this possible? It happens because investors are short-term oriented and try to time the market. They add money when the market is going up (buy high) and sell when the market is going down (sell low).

This is the opposite of what they should be doing (i.e. buy low, sell high). But either way timing the market is impossible, so the best way to achieve high returns is to remain invested in the long-term.

Analytical Approach

In finance there is a mental error called confirmation bias (we discussed it here). This is where investors go looking for information to support their existing view.

Add that to an endless supply of information on companies (i.e. annual reports, economic data, daily news, industry trends, expert opinions, quarterly financial data, etc) and things can get pretty confusing.

Recently, I’ve seen value investors slamming highly priced tech companies. They pick a couple of factors and start making a case against the company. It is easy to agree with them - their arguments are compelling. But are they correct?

I’ve also experienced it in the private equity industry. Investments discussions are like mud wrestling. You say this, someone else says that, you present this information, they present that information. It becomes a battle of egos, and since information is plentiful, there is no shortage of ammunition.

That is why here at the Rule of Acquisition, we approach investing with an iron fist (I’m trying to sound tough).

What we actually do is apply a rigorous analytical approach. We are clear on the core determinants of value creation and look to those as our North Star. These factors help us to keep focused on what is really important. And it gives us resilience against confirmation bias.

This is not to say that we only look at numbers, we also look at qualitative information, but we process it through a value creations lens.

Conclusion

Being an Extraordinary Investor requires all five of these criteria:

1. quality companies,

2. growth prospects,

3. a shareholder orientation,

4. an investor mindset, and  

5. an analytical approach.

Missing out one of them is tantamount to leaving investment returns on the table.

Happy investing!

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