A Global Quest for the Best Businesses

12/14/2017, Ticker Magazine

Businesses that create lasting investment returns are most typically growth-oriented, durable, and less cyclical. According to Matthew Benkendorf, CIO of Vontobel Asset Management, Inc. and portfolio manager of the Virtus Vontobel Global Opportunities Fund, owning such businesses in a concentrated portfolio is the best way to preserve and compound capital over time. That philosophy may sound simple, but it requires a global team, a steady focus on quality, and extensive research work.

 
 
"In our view, preservation of capital is not about market timing or top-down allocation, but about owning durable and predictable businesses."
Q: What makes the fund different from its peers? A: We are a high-quality, growth boutique that manages six different funds. The same investment professionals who run the Virtus Vontobel Global Opportunities Fund also simultaneously manage emerging markets, U.S., Europe, Far East ex-Japan, and international portfolios.

There are managers who also run several funds, but they typically have separate teams for each market. Our firm is different, because we manage all these funds simultaneously. As a team, we have a perspective on each sector and geographic level and we believe that approach makes us very efficient at the global level.

The Virtus Vontobel Global Opportunities Fund is at the top of the pyramid in the competition for capital among all of our strategies. While it represents the broadest geographic exposure, it is not simply a conglomeration of all the underlying geographic strategies because it is managed in a very concentrated style. We compare each company, name for name, to find the best businesses to gain entrance into the strategy, so it truly encompasses the best ideas across our regional strategies.

Q: How has the fund evolved through the years?

A: The Fund has a long history. We have always been focused on owning better businesses and, although our approach has evolved over a longer period of time, we have been very consistent for the last 15 years.

In the longer run, we have become more concentrated and more benchmark agnostic than our peers. That coincided with becoming more restrictive and highly selective in our intellectual pursuit of finding better businesses around the world.

Our investment approach is disciplined. We want to own only the best ideas. We believe that the businesses which create enduring investment returns are growth-oriented, durable, and less cyclical businesses that can grow to higher sustainable levels of profits. In our view, the best way to preserve and compound capital is to own these businesses in a concentrated portfolio.

Q: What is your investment philosophy?

A: The key elements of our philosophy are to focus on high quality, predictability, and sustainability. High quality means strong underlying economics, high returns on invested capital, identifiable moats around the business, and competitive advantages that often lead to monopolies or oligopolies.

In terms of predictability, we aim to buy businesses that are less cyclical and provide value to shareholders. We believe in a long-term pursuit of compounding capital, and the critical element is the preservation of capital as you compound it. In our view, preservation of capital is not about market timing or top-down allocation, but about owning durable and predictable businesses.

If you have to always get the cycles right, you can’t really be consistently successful over time. We believe the best chance of success is owning businesses that do not depend that much on these cycles and are sustainable — they can hold up better when the economic cycles hit the inevitable air pockets.

In terms of the growth element, we let the businesses do the heavy lifting for us. Our job is to find the great race horses and to invest capital in them like an old-fashioned investor. We do not see ourselves as stock traders and market timers. Rather, we deploy capital into equities and hold these equities over long periods of time. These equities generate investment returns through the business itself.

We withstand short-term volatility, because if a business can endure and sustain high economic returns, the market will reflect that over time. Our investment returns are driven by the quality of the business and its growth capabilities, which lead to preservation of capital and compounding of returns.

Q: How would you describe your research process?

A: Our research process is simple, but not easy in practice, because of its highly-disciplined manner. It begins with our proprietary quantitative screening that eliminates businesses. Since we look for businesses that can endure in different economic environments, we look for clean track records. We examine a number of basic variables, such as returns on equity, operating margin stability, balance sheet strength, as well as different metrics.

Our screens eliminate most of the businesses in the world, so we don’t waste our time on them. The most common notion of investing is turning over a rock to search everything, trying to understand everything, and being willing to own anything at the right price. That’s not us. We first eliminate most of the businesses and focus our intellectual pursuit on a much smaller pond.

Our quantitative screens narrow down the universe from about 50,000 to about 500 names. That’s when we roll up our sleeves as analysts. That process is twofold – it involves a backward-looking analysis and a forward-looking exercise.

When we research each company historically, we aim to understand what makes it a high-quality business and why it generates its returns. That step involves talking to the company and to contacts in the industry, as well as accessing all publicly available information. While it is not a highly complicated process, it is hard and grunt work. We look not only for companies that screen well economically, but for businesses and economic returns that we can truly understand.

The next step, the forward-looking proposition, is the key determinant of investment success. What does the business look like going forward? Can the business continue to do what it is doing by virtue?

I believe that approach lowers the risk as compared to investing in turnaround stories, companies with management changes or other issues. When you start with something broken, you try to determine if it can be fixed. Instead, we look for something that is already strong and growing, and we just try to determine if it can keep doing it. That’s the sustainability part of our philosophy.

As a result, we own a smaller number of business and they have similarities with one another. We typically end up owning many consumer-oriented companies because their profits are recurring in nature, the predictability is higher, and the incremental growth is a little easier.

Q: Do you have a macro overlay in your process? How important is the big picture?

A: We are aware of the macro picture, but we don’t have any top-down overlay in our process. We are entirely bottom-up and benchmark agnostic in terms of picking businesses. We pick the businesses globally and then they fit our geographically structured funds. Then they all compete for the global equity product. The macro level is more important in emerging markets, where we need to be cognizant of the operating environment, the political environment, the convertibility of currency, etc.

Q: Could you tell us about your research team and how an idea becomes a holding?

A: The team supporting this fund consists of 18 people and everybody is an analyst. Some people are also portfolio managers but, at the heart of it, we are all analysts.

A key part of our structure is that analysts are focused on multiple sectors. In the pursuit of great businesses, we want analysts to have a variety of perspectives. If analysts stick to just one area, they tend to become very myopic, while we want to find the best of everything out there.

The cross-comparisons and the intellectual broadness of experience are very important. Our analysts are working globally, with defined multi-sector responsibilities, but also with some specialization, because there is a benefit in building up accumulated knowledge.

We have double coverage of everything. We do not leave anybody working alone in any area, because we are long-term large holders of businesses with low turnover. We spend a lot of time on double-teaming and maintenance research of the companies we own. A great deal of our research effort is spent on challenging the names in the portfolio to make sure the investment thesis and the high-quality attributes are holding true and consistent.

Three of our investment professionals are former investigative journalists with no background in traditional financial analysis. One of the greatest risks of our style is becoming complacent. The investigative journalists help challenge our thesis and play the devil’s advocate around the investments. They keep probing and poking to make sure that we are on top of every small risk that can grow to a large one.

Q: You mentioned that your style naturally concentrates your portfolio in certain areas. What are they?

A: Yes, we have been more heavily investing in certain areas than in others over long periods of time. A typical investment area is Consumer Staples, or businesses with a lot of selling power that have recurring consumption.

We don’t own much in areas like energy, basic materials, commodities, or capital-intensive areas. We have found reasonable opportunities within Health Care, Financials, and Technology.

Technology has become a larger opportunity over time as businesses have become more established and dominant, which has led to more predictable growth. We typically don’t own the cutting-edge tech companies, because we don’t try to be early in the next best thing. Instead, we own well-established, highly predictable tech companies.

In the Consumer Staples space, we own a variety of businesses like food, liquor and tobacco, although tobacco is a bit different. Tobacco companies can represent long-term growth businesses. Although volumes decline over the long-term and the end market is shrinking, these companies have the pricing power and the underlying stickiness of their market.

That’s their strength and that makes them growth businesses. The growth generates free cash flow back to shareholders in the form of dividends and share buybacks, while earnings grow without the necessity for incremental capital investment.

The key is the economic business model. It has to be very predictable, not subject to rapid change, highly profitable, and not capital intensive. That would be the ideal case. In the case of tobacco, there is also pricing power and size.

So, we don’t have an initial bias towards a certain sector, but our concentration is the result of the business attributes that we look for. Since we look for more established companies with good track records and these established companies tend to be bigger, we end up investing in larger companies. For successful businesses, their large size becomes their strength.

Q: Could you give us some examples of holdings and elaborate on their attractive characteristics?

A: We focus on the basic business threat and we monitor any changes in the competitive dynamics. For example, the fact that tobacco is highly regulated is a huge barrier for competitors. That barrier doesn’t change overnight. Technology is more fluid and we own both the players that control more than 80% of the global digital advertising market.

In any model, it is important to understand whether the pie is self-growing and what’s the competition within that pie. That can be different in different industries.

For example, despite the disruption in the retail industry, we have found that the convenience store model is uniquely positioned to be more durable. In Canada, we own Couche-Tard, which also operates the Circle K brand in the U.S. We have also invested in Casey’s General Stores, which operates in the Midwest. In our opinion, those stores are not facing the same threats as department stores or drug stores, because we believe their business model is more resilient.

Q: How important is transparency and corporate governance in your process?

A: Governance is very important to us. We search for good businesses with good managements. The way the management allocates capital, its track record, how smart it is, its integrity and honesty, are among the key issues. We have high governance standards because we need the managements to steer business growth over a long period of time. We have to be comfortable with the ownership structure, its legality, and its risks.

Q: Do you establish price targets? What is your buy and sell discipline?

A: Yes, absolutely. We are eager to pay more for quality, because we derive investment value from the long-term nature of the businesses we own. If we have been right in identifying a better business, we would be rewarded by a longer, more durable, and higher-growth earning stream.

Nevertheless, we do have price targets and we put a value on everything we own. When our businesses reach those price targets, we sell or we reevaluate. As a holding approaches its sell target, we do position sizing.

When buying enduring growth businesses, we expect growing investment value. The price target can move up and we constantly reevaluate it. If the underlying economics and the predictable growth rate stay the same, the business value moves up. So we may ride an investment for a long time. Sometimes we have to sell ahead, but we continue to watch that business.

It’s an old-fashioned investing style, which works only with great businesses. With this investment style, we don’t have to recreate the wheel every year with cyclical, turn-around, average-quality businesses. We don’t have to buy and sell constantly, because the earnings power hasn’t moved up or the turnaround and restructuring story hasn’t come through.

That’s how we believe our style and philosophy makes it easier over the long term. We do pay more for these businesses, but the earnings stay durable and growth remains high. Despite being very restrictive, we end up with faster and real earnings growth. We don’t sacrifice anything in terms of growth by focusing on more durable businesses.

Q: How is your portfolio constructed? What is your benchmark?

A: Portfolio construction is also the result of aiming to own better businesses. Having larger position sizes means we have higher conviction in companies that we feel have better and more predictable underlying business economics.

We use growth as a lever in terms of capital allocation. When we distribute capital among quality companies, tilting capital towards faster growth would improve investment returns. That’s our strategy to compound the high-single, low-double digit returns through the cycle. All we need to do is find businesses with the right profile.

Our benchmark is the MSCI All Country World Index, but we believe that our philosophy of absolute returns and preservation of capital at a compounding rate can provide better performance relative to any benchmark over a longer period of time. The benchmark has a much harder time compounding at those consistent levels, because it is more diversified by nature. We believe diversification is important for the sake of risk management, not for the sake of being diversified across sectors or industries.

Q: How do you define and manage risk?

A: We believe that risk isn’t defined by beta or a measure of volatility, but by the businesses we own and what they do. These are the risks we focus on.

At the portfolio level, we diversify the underlying operational risks of the businesses we own, because we have the ability to own a basket of high-quality businesses. We make sure to allocate capital within that basket and to optimize idiosyncratic risks. Even within Consumer Staples, for example, we own businesses with different operational risks. The companies have different taxation and regulatory risks, different consumer consumption patterns, and different pricing power.

We make sure to be mindful and cognizant when we own those businesses and how we allocate capital across them to maintain acceptable risk.

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