Our Two Favorite Buys after a Stellar Q1
Buying more of the great stuff you already own
What to expect after a stellar Q1? We have no idea and it’s irrelevant
As you know, we’re interested in one thing only: achieving our absolute return goal. We don't care about the short-term performance and Q1 has been very good to many investors. So should we consider Q1 to be a lucky shot: time will tell.
Despite all the expert forecasts, nobody knows anything and assessing the economic rhetoric and share prices on a daily basis will make you become very short-term focused on data that simply aren’t linked to how our businesses are performing.
It will be interesting to watch our performance during periods of heightened volatility, resurgent inflation and thus uncertainty. We target positive alpha primarily during down markets, which forces us to think deeply about a selective group of outstanding compounders. Compounding starts with protecting the principal. Aside from the short-term narrative around stock market performance, we focus on the underlying NOPAT per share evolution (incl. share buybacks) and our companies' left-over cash flow being distributed back to shareholders.
Overall philosophy
Given that we already share our real-life portfolio and transactions with our community, elaborating more on our current three favorite buys should provide more insights into our personal allocation strategy over the next 12 months. As always, we don’t want to attach ourselves to a specific buy list or an opinion on a certain company. We’d better not become complacent about (short-term )return goals. But for now, we feel this list acts like a good starting point for new capital inflows.
As a reminder: as a long-term quality tortoise, we generally stick with what we own (even if the valuations of some of our holdings may have gotten ahead of themselves, except for some special situations where better risk-adjusted opportunities present themselves). Our strategy/substack isn’t about rotating in and out quality growth companies; instead we selectively invest in a group of companies we’ve analyzed thoroughly and which we intend to hold onto for a very long period of time.
In Q1, we published three deep dives that highlight our analysis process (what parameters do really matter?), IRR valuation model (and how to interpret it) and risk assessment.
Topicus.com - Can it outpace CSI’s future shareholder returns?
Autozone - The unmatched cannibal - what to expect going forward?
Quality growth investing should be like watching paint dry: place your bets, sit tight, learn from your mistakes, define your circle of competence and enjoy the ride. It takes quite some time to get to sufficient comfort level when analyzing a company. And it’s even more difficult to keep track of a very diversified portfolio. Especially in today’s world, the devil is in the details and thorough analysis is therefore where the significant alpha will come from over the next decade. Put another way, the following three names already sit in the portfolio but we would be very eager to buy more shares during the next dip.
Now, of course, we do - from to time to time - look at our list of potential candidates that are not in the portfolio as of yet. Some of them include:
OTIS Elevators
Ametek
Danaher
Amphenol
As we oftentimes remind ourselves of: what we put in should be a lot better than what we already have. Adding more lines to the portfolio because that could make you feel happier: it’s not a tactic we would recommend.
From a risk-adjusted and absolute return perspective, we’re more than happy with what we own. Investing simply isn’t about shooting for the highest possible absolute return, rather we should balance risk and return.
IRR Assumptions
Regarding our IRR model, it's not that difficult to calculate it as it's gathering all cash streams and the timing at which these are being generated. An excel sheet does wonders to figuring it all out. And anyone can build an IRR model: cash inflows, cash outflows and the dates/years at/during which they've been generated (that's all you need).
Of course, it's just a model and we should be cognizant of some important nuances, as highlighted in the recent webinars. https://thecompoundingtortoise.substack.com/p/webinar-how-much-should-we-pay-for & https://thecompoundingtortoise.substack.com/p/webinar-the-art-of-valuation
It all depends on your assumptions (ROIIC, reinvestment rate, overall profitability trends).
First, IRR is still a gross number. As companies generate excess cash flow, the IRR model assumes it ends up being paid out to shareholders simultaneously. In that case, we'll be taxed on the dividend. When there's a formal dividend policy, we can take taxes into account which make the IRR more realistic.
When there's no dividend policy, building up cash won't add any value to the realized returns for shareholders. Therefore, we want to companies to distribute all excess cash flow to shareholders, ideally through share repurchases. As I mentioned earlier, the lack of proactive capital allocation will be a drag on our performance. Moreover, we’ve found that smaller-sized companies that don’t apply a proactive allocation policy are at risk of getting delisted and or facing a permanent derating in their multiple.
The bottom line is: a high gross IRR doesn't necessarily equal high effective returns as we don't know how much excess cash flow will eventually end up on the balance sheet. It depends on the company's capital allocation policy (what will it do with excess cash?).
If it can find more reinvestment opportunities in excess of the cost of capital and the implied IRR (after tax in case they pay dividends), then our modeled base IRR will prove to be too conservative. This is effectively what has happened with Constellation Software: reinvesting more at IRRs that have exceeded our hurdle/base rate. We’re really bad at working out the magic of achieving consistently strong ROIICs and keeping excess cash flows low (by distributing them as dividends, through share repurchases and more CAPEX/more M&A at very attractive returns).
Contrary to dividend payments, the IRR model cannot factor in the effects of share repurchases (we don't know at which price they'll be executed, the amount of share buybacks, the potential use of incremental leverage that could be a positive when multiples are low and the instant return is already above the cost of capital).
Second, IRR does not take into account the return we can generate from reinvesting the net dividends received. IRR doesn't measure the compounding potential from generated excess cash flows and or net dividends received.
It boils down to constructing a realistic model, based on already-known information (dividend policy), reinvestment rate and ROIIC (own assumptions) and optionality (accounting for share buybacks).
Without further ado, here are our two favorite buys for new capital.