Quality & Sustainable Earnings
As Investment Directors at Kennox, we have 100% of our equity wealth in the Kennox Strategic Value Fund. Our objective is to make excellent, risk-adjusted returns for us and our co-investors in the Fund, delivering annualised performance over the long term which is in the high single digits or better (currently 9% net of all fees). At the same time, we are conservative individuals and we look to accomplish this with as little risk as possible. We believe that we have the best chance of achieving both – excellent annualised returns with limited risk – by sticking to a clear but powerful philosophy.
Core to our investment philosophy are two key tenets: quality and valuations. Quality, because we believe equities are risky (reducing quality increases the risk) and valuations, because the price you pay is the primary driver of returns you will make.
The valuation of a company, fundamentally, breaks down into two components: an assessment of a company’s earnings and the multiple an investor is being asked to pay for those earnings.
Typically, when discussing earnings, investors are referring to 12 month trailing, current or 12 month forward. At Kennox, when we look at earnings, our focus is on Sustainable Earnings: a conservative estimate of what profits (and cash flows) we expect the company to deliver in the future on a ten- or twenty-year time frame.
With a focus on the sustainability of earnings, we are naturally biased against peak earnings. In our company analysis, we discount peak earnings significantly seeing them as a risk better suited to growth managers and, in our view, best avoided. Why? Because at peak earnings, a company will almost always be facing increasing competition as new entrants are attracted to the most profitable and fastest growing sectors and industries (Capitalism 101).
For the Kennox value philosophy, it is much more logical to hunt for companies trading on off-peak earnings, where competition is likely to be shrinking and headwinds decreasing. In other words, we look at a company and ask if it can make earnings in the future that are merely unremarkable compared to its own past. This is not building in any heroic assumptions. Instead, by design and temperament, we are able to take an independently formed, long-term view and stick with it.
As this approach is naturally long-term in nature, we are not worried about the timing and shape of the earnings, i.e. if the earnings are lumpy or are shrinking in the short term. On the contrary, it is often only due to these shrinking earnings, and ensuing negative news, that we will get the chance to buy at exceptional valuations.
At Kennox, exceptional valuations mean not paying more than 12x our view of Sustainable Earnings of a company. There is substantial risk in overpaying, something that appears to have been forgotten judging by today’s market levels. Conversely, there are exceptional returns to be made from buying quality assets inexpensively. We are happy to invest when we find sensible and conservative valuations that imply returns that are commensurate with equities risk.
There are situations where we will get high quality companies at genuine discount prices. However, to really equate to an exceptional opportunity, there is one more, and most important, step – our detailed assessment of the level of quality.
In our assessment of quality, we look for certain hallmarks: a strong franchise, conservative management, low levels of debt, and a long-term track record demonstrating the ability to survive through multiple cycles. It is our aim to have each portfolio position exhibit these.
But to drill deeper on quality: we must truly test our conviction level on our evaluation of those Sustainable (non-peak, possibly-not-growing-in-the-short-term) Earnings, i.e. the quality of the franchise. We conduct in-depth analysis of the strategic positioning of the company’s products currently; looking across its customers, competitors, distribution, supply chain; always including studying past financials for clues and hints, going back two cycles or more; factoring in potential disruptors (new entrants, changes in laws and consumer preferences and working practices, costs); hunting out all the factors that contribute to the future success or failure of a business. In short, we drill down into all the fundamentals that will drive a company’s future profits on a long-term view. This takes time but, for us, is essential. It is only after we have done all the work that we really know our conviction levels about the quality of our Sustainable Earnings – that the headwinds are temporary, that the individual company has enduring strengths that will in turn be able to generate significant profits.
If we’re being offered the share at 12x or less, we have a compelling case. Where we can make exceptional returns is if the company’s profits can move back up to peaks or beyond, or if the shares are re-rated. Being self-reinforcing, these two often coincide, providing some truly mouthwatering returns. And importantly, this can occur irrespective of market direction or economic growth: our stocks have worked through their individual headwinds, giving them the ability to perform even in difficult times (as was our experience in 2008). This is one of the joys of our investment philosophy – in our decade working together, we have seen this outcome many times. We expect to find many more such opportunities in the future.
Our focus on paying only conservative prices and of assessing the quality of earnings on a longer-term view (often via a disregard for the lumpiness and timing of earnings) presents a coherent, logical and sensible value investment strategy. Because this is very different to what most investors do, the market will continue to offer up excellent opportunities for our style in the future. If we are selective about these opportunities and only pick the very best of them, we have a good chance of achieving our objectives – excellent risk-adjusted returns through all market conditions over the long term.