The market is not always efficient. A study by Randy Cohen  shows that even average active managers’ “best ideas” outperform passive strategies. Cohen shows that stocks which managers significantly overweight relative to a benchmark outperform by 5% per annum. Everything else dilutes this result.
Why do managers add mediocre ideas? One reason may be that they are incentivized to gather assets beyond their true capacity to invest. Other reasons may be fear of short-term benchmark underperformance or a manager’s desire to reduce volatility, which shouldn’t have much relevance to long-term investors or investors diversified across many managers. These are each rooted in the link between management fees and assets under management.
There is no single answer for how many investments a fund should hold. But generally speaking, active managers hold too many. After mixing in the results of mediocre ideas and subtracting fees, many funds fail to create value for clients. John Bogle, a critic of active management, has said, “The grim irony of investing is that we investors as a group not only don't get what we pay for, we get precisely what we don't pay for.”
The Partnership has three operating principles. The first, which generates investment ideas, is necessary, but not sufficient, to reach the Partnership’s goals. The other principles relate to how the Partnership is organized and the order of preference in the limited partner - general partner relationship. They are:
• an equitable fee model
• transparency, governance, and alignment of incentives
These help prevent principal-agent problems from diluting the performance of the investment approach. They also direct value created to the limited partners, as opposed to being retained solely by the general partner and service providers. Sol Price, a pioneer in the US wholesale warehouse industry, used to say, “If you recognize you are really a fiduciary for the customer, you shouldn’t make too much money.” Sol’s pricing strategy was not based on a percentage of the manufacturer’s suggested retail price, but rather a fair markup to the product’s cost.
The Partnership’s management fee is tied to cost as opposed to assets and capped at 1.0%. As assets increase, this fee will be reduced on a percentage basis. Our goal over time is for the fee to drop below 0.5%.
The markup is captured through Scott’s six percent hurdle-linked performance fee. This ensures the portfolio will be significantly invested, regardless of market volatility, when opportunities are fair to abundant. At the same time, it keeps limited partners in line ahead of the general partner. In order to improve the likelihood of surpassing the six percent hurdle, Scott’s portfolio is concentrated in eight to twelve holdings - just best ideas.
Any performance allocated to the general partner will likely be a fraction of the general partner’s invested capital, as opposed to a multiple thereof. Moreover, with my total net savings invested in the partnership, I suffer losses in lockstep with investors. Together, these ensure a capital preservation incentive. In the absence of opportunity, the Partnership will hold large cash balances.
What maximizes the potential for outperformance?
Cohen’s work is encouraging for investors who invest with active managers. But a wide brush approach is clearly wrong. According to Cohen, which fund attributes maximize the potential for outperformance? They are:
• focus (country, sector, or investment type)
• illiquid, overlooked, and inefficient markets
• better fee structures
• staying within capacity
Scott’s operating principles are no guarantee of success, but they significantly increase the chances of the partnership reaching its goals.
 Cohen, Randolph B. and Polk, Christopher and Silli, Bernhard, Best Ideas (March 15, 2010)
To generate industry-beating returns, it’s important to continuously sharpen an edge, or competitive advantage, over peers. In the people-centric industry of investment management, the attributes that make a difference are often less tangible than, say, Booker’s scale economies or Swedish Match’s customer captivity. While the advantages associated with investing in public equities are mostly of a type that needs to be cultivated rather than structural, they nonetheless exist.
I attribute our edge to three factors, all of which have been in place since the partnership began. They are:
Differences in applying a value approach. This can be subdivided into our focus and our entrepreneurial culture:
· By focusing on a limited set of frameworks and companies over a long period of time, our analysis and judgment may be better than other market participants in those areas where we have expertise. We sometimes pick up on subtle yet critical investment return drivers such as pricing model transitions, demand inflection points, or cultural uniqueness which are hard to otherwise notice.
· Our unconventional setup may help us avoid calamities and size excellent investment opportunities appropriately large, without being compromised by bureaucracy and rigid structure.
A network of outstanding, engaged collaborators. This comes from our limited partners and independent peers, who understand our ethos and interact in ways that help to reinforce it. For limited partners who share our investment philosophy, time horizon, and tolerance for market swings, the potential upside is outperformance. For peers and supporters who share insights, experiences, and counter arguments, the benefit is, hopefully, fresh perspectives and mutual learning.
Size. This allows us to invest in small (as well as large) companies. Though not a rule, small companies tend to be less efficiently priced and offer greater opportunities to add value through active management.
By actively cultivating these factors they can be sustained and enhanced. That means taking time away from routine activities to devote energy toward more lateral thinking and deepening personal relationships. By doing so, I hope that the presence of an edge will eventually become evident in the results we produce over a market cycle.
Don’t take my argument as a sign of built up overconfidence. Instead, take it as an answer to an important question that I would want to have explained if I were in your shoes.
The following is from the opening pages of Zen and the Art of Motorcycle Maintenance , written by Robert Pirsig, who died earlier this year at age 88:
“Chris and I are traveling to Montana with some friends riding up ahead, and maybe headed farther than that…Secondary roads are preferred. Paved county roads are the best, state highways are next. Freeways are the worst. We want to make good time, but for us now this is measured with emphasis on ‘good’ rather than ‘time’”
Among other themes, Pirsig’s novel deals with the nature of quality. It was one of the first books recommended to me when I started in investment management. I believe my boss at the time, Burkhard Wittek- who suggested it, was trying to impart that the work should be viewed, like law or management consulting years ago, as a profession rather than a business. This was not to make the activity sound grand. It was to get me to screen out what others were doing and focus on first principles to improve our odds of exceeding a highly set bar for results. Constant attention went towards understanding the source of outcomes, rather than the outcomes themselves. I’m grateful to mentors, friends, and partners in Scott’s network who have tried to convey wisdom like this to me over the years. Hopefully, some of it is soaking in.
 Pirsig, Robert M. Zen and the Art of Motorcycle Maintenance: An Inquiry into Values. New York: Morrow, 1974.
During the second half of the year, the Partnership made one new investment and sold an existing holding. Keeping the portfolio around ten positions reduces complexity and allows me to thoroughly understand each investment, while still maintaining a comfortable level of diversification. Edward Tufte, an inter-disciplinary scholar of information design and political science, has said, “Clutter is a failure of design, not an attribute of information.” I couldn’t agree more.
During 2016, Hilton Food Group, our UK listed meat packer, achieved its twelfth consecutive year of volume growth. A prominent element of the Partnership's concentrated investment strategy is a preference for companies like Hilton that create value in a stable, consistent manner.
Firms like Hilton operate successfully even in harsh economic conditions. While Hilton's results may be temporarily suppressed below their long-term potential in such conditions, the company has the staying power to outlast a downturn more effectively than its less resilient competitors. By focusing on superior, well-capitalized, high-return businesses like Hilton, the Partnership seeks to protect its fortunes from the vagaries of the unpredictable future.
However, when looking for new investments, I don’t start by running an automated screen for twelve years of continuous growth, or any other formulaic combination of quantitative financial metrics. Historical financial ratios can be misleading indicators of current business quality and future operating results. Nor do I begin by flipping through the daily 52-week low list for cheap stocks. While our new investments might show up there, most 52-week lows aren’t companies worth owning over a five or ten-year horizon. If one assumes that investing knowledge is cumulative, but also that it’s impossible to truly follow more than, say a hundred companies, these search strategies seem short sighted for a focused portfolio.
Instead, I prefer starting with “A” (for example, Aalberts Industries NV) and working my way to “Z” (Zytronic plc). I use simple frameworks to identify companies with business attributes that are sustainable and scalable. When these qualities combine with a capable management team making thoughtful operational and capital allocation decisions, a closed loop of cash generation, redeployment, and value creation forms. It compounds wealth over time without the need for frequent portfolio changes. In this way, I focus on the inputs, not the outputs. Eventually, the inputs should determine the outputs.
Although time-consuming, this method is a rewarding way to find companies. I benefit from having few distractions and having read about the same universe of businesses for a long time. Today, I keep tabs on about one hundred companies, or approximately 3% of listed stocks in Europe. Some would pop up in quantitative screens (e.g. Swedish Match), while others probably would not (e.g. Cairn Homes, Addlife, or Wizz Air).
By studying a limited subset over an extended period of time, any personal infatuation I initially felt with these companies’ recurring revenue, high margins, or float has, by now, worn off. The inherent qualities remain appealing, but the businesses don’t feel new, or limitless. Scuttlebutt research has identified the non-“Porter’s Five Forces” risks (e.g. the wrong people, questionable accounting, or legal and regulatory question marks) that crop up in certain excluded companies. I have also developed a greater appreciation for the management, culture, and customer relationships at some companies where the business description, industry topography, or financials don’t simply jump out at you.
In the case of Hilton, for instance, the company fits my framework for a business with a low-cost position in a large, fragmented industry producing a commodity product. Consequently, it has been able to gain market share and grow at a faster rate than its peers. While competitors are barely earning their cost of capital, Hilton earns a very acceptable rate of return.
The figures below include data on Hilton, Booker, and Wizz – each portfolio holdings which follow this model. They optimize for unit cost and then offer low prices to attract volume. As output grows, they cut prices further, bolstering relationships with customers. All the while, they continue to earn a return on invested capital (ROIC) that is superior to their peers.
Dolly Parton once quipped, “It costs a lot of money to look this cheap.” The founders of these companies had some version of this focus on unit cost, drive down price, broaden market share - script in their minds at the outset and have continuously invested in realizing their vision. Once a low-cost producer in a stodgy, commodity-producing industry, unleashes a zeal for using price to stimulate demand it’s tough to stop them from steamrolling the competition.
I spend my days looking for and deepening my knowledge about companies that embody this and other frameworks. Watching and waiting, we buy them under a few scenarios.
· Sometimes, investors get flighty about a short-term problem. We can take a position based on a long-term expectation while others are rushing for the exit. Our buy of Wizz Air fits with this description.
· At other times, a stock can go nowhere for a few years while the business continues to develop its cash flow and balance sheet at a healthy, but not attention-getting, clip. Eventually, like a base-runner taking a lead off first, the future return can sneak into a compelling territory. Hilton, Swedish Match, and Vopak fell into this camp.
· I also keep an eye out for businesses that should accelerate, but where the change is not yet showing up in reported numbers, analysts’ financial forecasts, or the stock price. CompuGroup Medical and our most recent investment match this scenario.
· Lastly, sometimes newly listed, spun-out, or restructured companies, can be left in a void of readily available information or a region of institutional breakdown which causes the market to become inefficient. When investing in Cairn Homes, I described why investors would, by nature, have difficulty buying at that time, regardless of price.
Getting back to frameworks; consider portfolio company CompuGroup. It’s a mature business which is growing, but not fast enough to attract fresh competition, and where rivals have difficulty achieving scale. This creates a natural barrier to entry, rapid returns on capital, high operating margins, significant free cash flow, and opportunities for CompuGroup to make peripheral acquisitions of companies with disproportionately high operating costs.
The historical metrics in the table below illustrate the attractiveness of CompuGroup’s model:
Over the period, CompuGroup reinvested 64% of its net income, achieving roughly a 19% rate of return– (15% - 3%) / 64% –and boosting net income growth by 12% annually. Another holding, Addtech, operates a very different business model compared to CompuGroup, but it follows a similar framework for redeploying earnings.
As an industrial distributor, Addtech functions as an intermediary in fragmented, low growth industries where a lack of available structural competitive advantages means it is hard to steal market share rapidly. But a focus on culture, business processes, and execution allow the company to churn out fantastic capital returns. Addtech’s comparable numbers  are:
I mention Addtech because, while I prefer outstanding companies, the portfolio is not necessarily a “top ten” list of businesses. Valuation matters–a lot–and it’s a mistake to disregard price, even for the best business. While an industrial distributor like Addtech might be an inferior business to say, French cosmetics giant L’Oreal, there’s nothing wrong with workhorse investments, if market prices warrant it. As former world number one tennis player, Pete Sampras once remarked, “I never wanted to be the great guy or the colorful guy or the interesting guy. I wanted to be the guy who won titles.”
A third framework the Partnership uses sketches out companies that can substantially increase the user value they provide to customers and, consequentially, can raise prices without imbalancing the customer contract, both written and understood. This is a rich source of value creation. Though not exclusively, many companies that fit this description are associated with expanding networks, where the service becomes more valuable as the number of users increases.
The Partnership recently invested in an enterprise software company which is in the nascent stages of an operating environment migration which will bolster prices. Because of its early entry into the market and local aspects of its business, it is dominant in its regional market.
The company’s revenue mix is shifting from a traditional, on-premise software model to a cloud model. The latter has several customer benefits. Client-side hardware is “thin”, reducing wasted computing power and expense. Bulk-purchased licenses, where many seats or features often remain unused, are replaced with an à la carte pricing where customers only pay for the software which is consumed. Finally, because upgrades and reliability are ensured centrally, at the hosting site, it's not necessary for customers to staff an in-house IT support team for fixes and improvements. In certain industries, such as retail, with its dispersed network of numerous locations, the benefits of these differences are profound.
These benefits are shared between the software provider and the customer. As such, revenue per customer increases. Over ten years, at our holding, I estimate that revenue per cloud customer should be 40% higher than a comparable on-premise customer. Operating costs increase due to hosting, but track well behind the revenue uptick. The profitability should increase sharply.
This transition should be treasured by shareholders. However, accounting standards muddle the picture. For on-premise software, customers pay an amount, call it 100, in the first year for the license and 18 in each subsequent year for maintenance updates. For cloud-based software, customers pay roughly 35 every year for a package that bundles the license, maintenance,and hosting (i.e. hardware). As the income statement captures what occurs in a single period, as opposed to a lifetime value, the transition has a depressing effect on revenue growth and profit margins.
This dynamic is hopefully creating an opportunity for the Partnership. Making some assumptions about normalized profitability and excluding cash, we invested at a mid to high single-digit earnings yield. From a point-in-time perspective, maybe not statistically cheap. But, when considering the durability of earnings and looking from a rate of return perspective, it’s compelling. Earnings are fully distributed to shareholders - while the capital-light model does not restrict sales growth,which measures approximately 12%.
This distribution policy is commendable, if not, at times, overly-conservative. Our holding is still run by its founder. A downside of many capital-light businesses which throw off a lot of cash is a propensity for appointed management to spend it foolishly – destroying value for shareholders. Though widespread in the software industry, our owner/operator doesn’t seem to be wired this way.
Case in point: intangible assets as a percentage of sales at the company are 2%, which compares favorably to the same metric at a few of the large enterprise software companies such as Microsoft (26%), IBM (44%), and SAP (130%). This divergence suggests that profit margins may be understated at the Partnership’s holding and that management is less likely to make poor acquisition decisions.
It’s worth stepping back from the trees (companies and frameworks) and reiterating what should drive Scott’s results from a forest-level perspective. The Partnership’s three operating principles are(i) a focused, value-oriented, investment approach; (ii) an equitable fee model; and (iii) transparency, governance, and alignment of incentives.
The Partnership will close to new LPs at an amount where we preserve a clear size advantage – we will be able to invest in $100m market cap companies as easily as we can invest in $100bn market cap companies. As the Partnership matures, additional capital can be accepted opportunistically, but it will be from existing LPs as opposed to new investors.
Our partners have permanent capital and think the way I think. They encourage me to focus on the destination,putting one step in front of the next, as opposed to asking what has been achieved this quarter. I’m grateful to have partners that reinforce the mindset that it’s a marathon, not a sprint.
These attributes are no guarantee of success, but they significantly increase the chances of the Partnership reaching its goals.
Edward Tufte, discussing his unconventional decision to self-publish his first book in 1983 (five thousand were originally printed and, by now, over a million have sold), wrote “My view … was to go all out, to make the best and most elegant and wonderful book possible, without compromise. Otherwise, why do it?”
 If you’ve never heard Southwest Airlines’ charismatic founder, Herb Kelleher, discuss the airline’s history and its use of low prices to win customers (Wizz copies Southwest), this recent “How I Built This” podcast is entertaining and informative: https://www.npr.org/player/embed/502344848/502624633.
In it, Kelleher recounts his message to employees, “Think small and act small,and we’ll get big.”
 (keep in mind that unlike CompuGroup, Addtech’s results were affected by an unusually fierce industrial down cycle which had a depressing effect on organic revenue growth during the displayed period. Over a more normal cycle, Addtech achieves organic revenue growth closer to 3% per annum.)
 Tufte, Edward R, The Visual Display of Quantitative Information (Graphics Press, 2001), Introduction to the Second Edition.
In investing, the only thing it makes sense to be dogmatic about is price (in relation to value). That may not seem like a high bar, but investors are affected by all kinds of institutional and behavioral factors which cause price to be ignored when making capital allocation decisions.
Strong investing foundations are built on low price strategies (low price-to-book, low price-to-earnings, etc.). These are easy to internalize and powerful in that it’s hard to lose money employing them, if adhered to, over time. Walter Schloss, who beat the market applying these strategies for a half century from 1956 until 2002, compared his operation to a retailer, “we are like a kind of store that buys goods for inventory (stocks) and we’d like to sell them at a profit within four years if possible. We receive some income while we wait which is more than a store does but, unfortunately, we have to wait for someone to come along a make our merchandise go up in price. We can’t do this ourselves by running sales”. At a low enough price, a stable, low return on capital business is a preferable investment to a great company at a fair price. I consider these opportunities. Ideally, management and the industry are unable to degrade the value of the asset, and the investor can get a sense of how and when fair value can be recognized.
Over time, however, frictional costs eat away at returns generated by first-order low price strategies. If a company’s reinvestments can be worked into a multi-period framework, holding periods lengthen, friction decreases, and gains come from earnings snowballing as well as value recognition. But it’s easy to be too smart by half – over confidence and the pari-mutuel nature of the stock market significantly increase the risk of heavy losses when employing this, sexier, strategy.
First, investors too quickly dismiss the nature of competitive markets to mean-revert capital returns, capping the period during which value is created. For example, as the dominant consumer electronics retailer in America, Circuit City’s advice-driven model, which worked in the late ‘80s as product variety exploded, was replaced by Best Buy’s warehouse model in the late ‘90s, which has since been partially supplanted by Amazon’s internet model.
Second, investors forget that agents (the board and management) are typically responsible for allocating owners’ capital. Take a more durable industry like telecom, and consider the Spanish incumbent, Telefonica. In 2005, it produced € 9bn of EBIT and a pre-tax ROIC of 22%. Over the subsequent decade, 30% of operating cash flow was dividended to shareholders. The remaining 70% was reinvested, either in the business or repurchasing shares. Management’s investments in numerous international markets look more like empire building than stewardship. At the end of the period, invested capital had grown by € 30bn, but EBIT cratered to € 3bn - the buybacks were a dumpster fire. Shareholders received a 3% annualized total shareholder return over the decade; entirely attributable to the dividends. Using similar assets in their own local markets, Deutsche Telekom and British Telecom returned 9% and 11% per annum. The difference in the gain was 5x, 184% at British Telecom vs. 34% at Telefonica.
Herein lies the importance of management in strategic decisions, allocating capital, and shaping culture. To do exceptionally well on an after-tax basis (i.e. in a single company over an extended period), management increasingly becomes the driving variable in a function that is a product of price, quality, management, and time. They forcefully skew the distribution of long-run outcomes. That’s why I try to stuff our portfolio with management teams that “get it”. Founders run 45% of our companies; the average tenure of management is fifteen years.
Even with our conducive setup, investing is competitive and arduous. As the number of investors who purchase stocks based on quantitative factors that focus on historical financial results and price movements grows, an approach that focuses on evaluating underlying business dynamics and management capabilities seems as sensible as ever.
At the end of the period, the Partnership invested in Wizz Air plc, an ultra-low cost air carrier (ULCC) connecting Western and Central/ Eastern Europe. It’s been managed by József Váradi since its 2003 founding. In an industry notorious for value destruction, the ULCC sub-segment has historically been an up-and-coming neighborhood in a dangerous city. For every decision that involves a tradeoff between revenue maximization and cost minimization, the ULCC strategy is to always minimize cost. The resulting cost position is not designed as an offensive against traditional carriers, but rather to expand the air travel market to previously un-reached, higher price elasticity, demand. Some ULCC decisions are big and easy to identify:
· fly large, fuel efficient planes and pack in as many seats as possible to spread fixed costs
· operate a uniform fleet to reduce maintenance expense
· fly point-to-point, rather than hub and spoke, to increase utilization
· cross-function employees to increase labor productivity
· fully de-bundle pricing to reduce variable costs of baggage, food, etc.
· be outrageous to stimulate media attention, while keeping marketing expenses low
· keep a hefty liquidity position
But Wizz’s neighborhood has boarded up houses, too. In reality, there are hundreds of smaller decisions with less obvious answers. Which routes get prioritized? How are planes best acquired and financed? Success is linked to experience curves and execution. Having a copy of the ULCC playbook is not the same as having won a few championships. With William Franke as Chairman and controlling shareholder via Indigo Partners, Wizz is well coached. Franke was CEO of America West Airlines, an early investor in Ryanair, and Chairman of Spirit Airlines. He has cumulatively managed a few billion passengers flown vs. Wizz’s hundred million.
Wizz’s unit cost is below every carrier in Europe, save Ryanair, which is comparable. They are of similar size in the geography, and together, dominate the local ULCC market with a combined share of 75%. They have historically been tough, but rational competitors - focusing on growing the pie, rather than dividing it up. I note that Ryanair’s Chairman, David Bonderman (of Texas Pacific Group), is a long-time business associate of Franke.
Since 2007, Wizz has grown passengers at 23% per annum. After adjusting for operating leases, Wizz achieves an after-tax return on invested capital of 19%, despite immature routes. Going forward, earnings will be reinvested into capacity increases which could result in a mid-teens rate of earnings growth over the next decade.
The partnership invested at a single-digit multiple of earnings. After capitalizing leases, the multiple of enterprise value to net income was roughly eleven. Prior to investing, the Euro converted share price declined sharply on Brexit related fears, which I feel are likely misplaced.
 WalterSchloss, “Seminar in Value Investing” (Columbia Business School, 1993)