When it comes to long-term investment performance, two of the biggest advantages an investor can have are 1) a Strong Investment Process, and 2) Low Costs. We stress the importance of both in every presentation we do. They are two of the fundamental pillars around which we have built our business. Good investment managers should talk about their process, while cost-effectiveness has been topical in investment media in recent years.
There is a third big advantage that every investor should look for, but almost no one talks about it: 3) Breadth of Investment Opportunity Set. To put it plainly – how many stocks are you looking at? It’s all very well to have a great process, but if you’re applying it to 100 stocks your results over time aren’t likely to be as good as the same process applied to 1 000 stocks, or 5 000 for that matter.
There are about 7 000 stocks listed across the globe that offer sufficient liquidity for us to make sizeable investments in. Of these 7 000, roughly 30% are of potential investment quality by our standards. Further, of the 7 000, roughly 30% are reasonably priced at present. This means that only 9% of the available investment opportunity set warrants potential investment under current conditions. Within this 9% there is a small group of companies that really ticks all the quality boxes and is very attractively priced – call this group the One Percent. A good stock selection process is all about finding that One Percent. Consider the following visual interpretation. The small red square is where Bellwood Capital aims to invest:
But… What if you’re only looking at 100 stocks in the first place? Are you going to put everything into 1 company? Of course not – it doesn’t matter how good the investment merits for any specific company are, something can always go wrong. So maybe you’ll buy 9 companies – accept slightly lower quality and higher valuations for a bit of diversification – you’re still in the top 9%. Unfortunately you’re still not well diversified, particularly if the 100 companies in your opportunity set are all in the same country/market. So maybe you’ll invest in 20 companies. But now you’ve invested in the 20%, not the 1%, so clearly you’ve made big sacrifices in terms of quality and valuation (i.e. long-term return) for the sake of reasonable diversification.
This needless balancing act between quality, price and diversification can be avoided by considering a much wider opportunity set. But herein lies another problem: Very few investment managers (multinational institutions included) have the capacity or tools to properly consider a really broad investment universe. Common hallmarks of this are portfolios consisting predominantly of large cap stocks with well-known names from major markets in the USA, the UK and Switzerland. This barely scratches the surface of what is really available to investors.
This is also the reason that it makes very little sense to focus all your investments in one country, one industry or one market. Far better to be a global investor and invest in the 1% representing your best ideas than to invest in 20% or 30% of a limited opportunity set. With a good process you will have better quality, better valuations and better diversification.
There are two important questions to ask any investment manager: 1) How many stocks do you hold? 2) What is your investment universe, and how much of it have you properly analysed? This will give you a good indication of the level of diversification in the portfolio, as well as the percentage of the opportunity set that has been invested in. If that percentage is too high your portfolio is unlikely to be invested in good quality companies acquired at attractive prices.
At Bellwood Capital we are truly global investors. We have the capability to give all 7 000 stocks fair consideration. How? Our process is focused on a few non-negotiable quality characteristics that have direct, mathematically demonstrable causality with return. Our analysis tools are geared to working through a very large number of companies and tracking them in real-time. We know which are the potentially high quality businesses, and we know as soon as they become priced for potentially attractive returns. With the 9% squarely in our sights we are able to spend time applying the rest of our process to identify the final 1% that makes it into our portfolios.