Many investors seem to have the wrong idea about monitoring stocks. They focus almost exclusively on share prices. Of course, the development of share prices is significant, but the most important thing to a long-term investor is the growth of the company’s capacity to make money.
In this article, we discuss how the Sifter Fund team monitors the Fund’s 30 long-term equity investments. This is a follow-up to our previous article on what kinds of companies are a good fit for a long-term investor’s portfolio.
Instead of share prices, focus on a company’s capacity to make money
You need to do your homework. Before you make an investment decision, you need to conduct a comprehensive analysis of the company. Even when that stage is finished, there is still more homework to be done.
Companies are living organisms. Their earnings model and competitive advantages may suffer. Also, changes in the industry may diminish their capacity to make money.
Regular monitoring is vital.
So, what are the 5+1 aspects should you focus your attention on?
1. Investment hypotheses
Before making an investment decision, you should summarize your investment hypotheses. In other words, what are the 1–3 things that justify this investment in particular?
For example, in the case of Starbucks, Sifter’s investment hypotheses are based on the growth of same-store sales of existing coffee shops and the growth of the new coffee shops in the Chinese market. In addition to these two key indicators, we keep a close eye on changes in the company’s margins and return on capital, investments, the intensity of competition, and the growth of digital services.
Investment hypotheses are the engine of growth and they underpin our belief that Starbucks, for example, will increase its capacity to make money in the future and the investment will be profitable for the shareholders. This is why we closely monitor to what extent our chosen investment hypotheses are realized.
2. The earnings model and competitiveness
At the time of making an investment, you need to understand how the company makes money and why its margins or return on capital is higher than its competitors. The earnings model is the engine by which a company makes money.
The deterioration of a company’s competitive advantage is usually a slow process. It is difficult for an investor to assess whether a decline in competitive advantage is temporary or permanent.
For example, the US-based Intel has been one of the world’s largest semiconductor manufacturers for a long time. Intel’s best-known products are microprocessors, which are used in computers, among other applications. In recent times, Intel has gradually lost market share and its technological advantage has diminished.
The situation came to a head in the fall of 2020, when the company admitted that they have not stayed on schedule with regard to their production technology. The announcement led to a change in CEO and widespread rumors about Intel’s period of dominance in the semiconductor industry being over.
At Sifter, we monitored these worrying developments for more than a year before finally deciding to put an end to our seven-year journey with Intel in October 2020. We replaced the company in our portfolio with a business that we believe represents higher quality.
Intel may well be able to improve its operations some day, but we fear that this will take a long time. That is why we decided against increasing the risk of our investors and we divested our holdings in Intel. The investment in Intel generated a return of 110% for Sifter Fund’s investors (excluding dividends, 2013–2020).
Want to read more cases? Download our guide: Long-Term Quality Investing. In the guide, we explain Sifter’s approach in more detail and cover five cases that exemplify the high-quality companies in the Sifter portfolio.
3. Mergers and acquisitions
All large listed companies make acquisitions. Some even make hundreds of acquisitions per year. Small acquisitions are usually not a signal of risk, especially if the company does not pay a price that exceeds its valuation or if the company has a strong track record of successfully integrating acquired businesses in the past.
However, there may be cause for concern if:
- the acquisition adds a significant amount of goodwill to the balance sheet,
- the company’s debt increases too much,
- or the company cultures are clearly different.
Large mergers always take up some of the senior management’s focus and create risks for shareholders.
Under Sifter’s investment strategy, large mergers and acquisitions always lead to a reassessment of the investment and potentially the decision to sell.
4. Changes in senior management
In small companies, the executive team is almost always the key to the company’s success. Even in large listed companies, the senior management is surprisingly significant, especially when it comes to decisions on capital allocation (investments) and building the company culture.
Unexpected changes in senior management are always a red flag in Sifter’s monitoring process for its portfolio companies.
When a new CEO is recruited internally and the shareholders have been informed of the change ahead of time, the risks to the investor are often small. However, if a change of CEO is sudden and the new CEO comes from outside the organization, the investor’s risks are increased. It is a sign that the company is probably seeking a change to its existing strategy.
For us as shareholders, a new strategy represents a risk that we need to carefully evaluate.
5. Profit growth vs share price
One of the most important things we monitor is naturally a company’s profit performance. In Sifter’s analyses, profit performance is estimated using a five-year horizon. Consequently, poor performance in an individual quarter does not lead to a decision to sell.
If a company’s profit performance lags behind targets for several quarters and the management’s explanations are inconsistent, we will consider replacing the company in our portfolio with a better investment.
For example, in the Swedish company Atlas Copco, the growth expectations of one business area lagged behind for several quarters, causing concerns among Sifter analysts. Nevertheless, the management’s explanations were consistent and the investors’ patience was finally rewarded in Q4/2020. The growth of Atlas Copco’s profitability was in line with Sifter’s investment hypothesis. We did not sell our holdings.
Upward or downward movements in share prices alone do not constitute a reason for us to sell our holdings if a company’s earnings model generates money at a growing rate.
Sometimes, we come across situations in which a company’s share price has become decoupled from its profit performance.
For example, we owned shares in iRobot in 2020–2021. The share price rose sharply in late January 2021 and became completely divorced from its fundamentals. In other words, iRobot’s share price no longer corresponded to its capacity to make money. We quickly reassessed the situation and sold our shares in iRobot for a return of 230%.
Unexpected situations
Companies sometimes face unexpected problems. For example, the world’s largest chain of coffee shops, Starbucks, saw its brand take a hit in 2018. The company was accused of racism based on how it had treated customers at one of its branches. The share price dipped momentarily and the market wondered whether mass boycotts against Starbucks would become a widespread phenomenon.
Fortunately, the company took the situation seriously and provided racial bias training to 175,000 of its employees. This calmed down the markets and customers. Starbucks’ business did not suffer any permanent damage. At Sifter, we increased our holdings in Starbucks after this incident.
We believe the key is to always determine whether a company’s money-making-capacity has been diminished permanently or temporarily.
The North West Company, which is a niche retailer, felt the power of a hurricane in the Caribbean in 2017. All of its stores on certain islands were destroyed. Even though the company had adequate insurance cover, the hurricane had a significant negative impact on its profits.
These types of circumstances are entirely beyond the control of senior management and shareholders. From the perspective of monitoring investments, surprises are very difficult to deal with. All shareholders can do is wait, sell or buy more shares.
High-quality companies can make it through storms without permanent damage thanks to their strong company culture, healthy balance sheet, and competitive advantages.
Sifter’s consistency and self-discipline create added value for investors
Analyzing and monitoring companies is a full-time job and psychologically difficult. There is little room for emotion and uncertainty is ever-present. At Sifter’s investment process decision-making in difficult circumstances is made easier by two things.
- We know our companies – our analyses are very comprehensive
- Sifter has a clear monitoring process and criteria for what is monitored
When the stock markets are nervous, knowing the companies you own gives you peace of mind. Unexpected news and dips in share prices do not make us push the panic button because we know that the high-quality companies we own are healthy and they have strong competitive advantages.
Consistency and self-discipline are put to the test in difficult situations.
The Sifter Fund has a team of eight experts to operate in accordance with predetermined processes and guidelines. In other words, Sifter investors have outsourced part of their wealth to this team and benefit from its full expertise at a reasonable price.
Long-term quality investing is an apt description of Sifter’s investment strategy. We have also written a 20-page guide about Long-Term Quality Investing.
Santeri Korpinen
CEO, Sifter Capital Oy
