Over the past three years, we have thoroughly researched 77 companies that appeared to be of high quality, but ultimately invested in only seven new ones. What were the main reasons we didn’t invest in most of the companies the companies?
At the end of November, the Sifter team gathered to review whether we had rejected potential investments for the right reasons.
When we looked back over the past three years, the main reasons for rejection were:
- Unclear Competitive Advantage
- Stagnant growth
- Excessive Risk
We also examined how the stock prices of the rejected companies have changed since the decision to reject them.
How does Sifter’s stock rejection process work?
Selecting the world’s best stocks is like looking for a needle in a haystack. Through the Stocksifter method, we reject over 95% of the 65,000 publicly traded companies as non-quality entities. This leaves a limited universe of a few hundred companies for investment opportunities, making it much easier to find a favorable quality company.
Even though we exclude many countries and industries, we ultimately do not select companies based on their home country or industry. The quality of the business is ultimately all that matters.
Lack of clear competitive advantage – The main reason to reject a company
The concept of competitive advantage is a term widely used in companies’ strategies and earnings presentations. Despite this, we believe that only a fraction of companies have sustainable competitive advantages that are reflected in their superior business numbers over a long period.
The best companies have developed a flywheel effect, where results improve as the pace accelerates. We are interested in these companies.
For example, we believe the American retail chain Costco has one of the most clearly observable competitive advantages in their business model. We wrote about this in our blog: Costco – An Impressive Money-Making Machine.
We rejected every fifth company from those we studied due to unclear competitive advantage. Companies representing this category included for example Garmin and Rockwell Automation.
When we examined how the stocks of companies with unclear competitive advantages performed, the message was quite clear.
Lesson for Long-Term Investors
Even though the research period is relatively short, it gave us a clear message. Do not invest in a company whose competitive advantages you do not understand or that does not have them. Strong competitive advantages often provide better margins, predictable results, and peace of mind for the investor.
Slow or stagnant growth – Potential value trap
When we analyze companies as potential investment targets, we try to estimate what the company will look like in five years. How and where will revenue originate, how will margins evolve, and how will the company’s industry and end-demand develop?
Sifter is not a growth company fund. Therefore, we do not invest in companies where growth is more important than profits. On the other hand, we are not value investors for whom only earnings and cheap stock valuation.
Out of the 77 companies we studied, ten were rejected due to stagnant or potentially stagnant growth. The main reason to reject is usually that there is not enough growth in the industry. Stagnant growth often leads market share competition or foolish acquisitions.
We believe, for example, that the American technology giant Cisco Corporation is in such a situation. Cisco is cheap, but growth is not in sight. Among the stagnant companies we rejected during our research were Generac Holding and others.
Lesson for Long-Term Investors:
A long-term quality investor wants to own growing companies from industries with robust end-demand and where the company does not get drawn into price competition in market share battles. Stock price growth requires growth, and end-market growth accelerates the majority of companies’ future growth.
Too risky a company – Avoiding opportunism
Sometimes we study companies that meet many quality company criteria, but uncertainty about their future money-making ability is high. These often include, for instance, the launch of new drugs by pharmaceutical companies.
Among the companies we studied, we rejected the iconic Italian fashion brand company Moncler and the Israeli company SolarEdge, specialized in solar panel management solutions. Neither company’s stock has done very well during the review period.
Lesson for Long-Term Investors:
Excessive opportunism can be expensive, so there is no place for opportunism in the Sifter Fund’s investment process. If a company feels too risky, we do not invest in it. We prefer to pay for predictable money-making ability, which brings peace of mind to us as owners.
Two surprising findings
Ethical reasons prevented us from investing
Firstly, we rejected high-quality looking companies for ethical reasons. These were not traditional companies against ESG metrics. For example, we rejected a drug manufacturing company related to a very rare disease, Vertex Pharmaceuticals. We thought, is it right to charge hundreds of thousands of dollars a year per patient to keep a person healthy or alive.
On the other hand, we invested in Novo Nordisk in 2020, which we believe meets the criteria for a quality company and our ethical criteria excellently. Novo Nordisk’s stock price has risen even more than that of Vertex Pharmaceuticals.
High valuation divides opinions
Secondly, too high a valuation was not always a reasonable reason to reject a company. We know from experience that very high-quality companies are never the cheapest, but we also do not want to pay too much for just expectations.
For example, we rejected the data analytics company Fair Isaac Corp, which focuses on credit rating services, and it has risen 144% since our rejection decision. At the time of research, Fair Isaac’s P/E ratio was 40, and now it is already 66. So, even if we had invested in this company, we would likely have already exited due to its too high valuation.
High valuation is justified when business results follow suit. However, if expectations are disappointed, the decline can be significant. In other words, we want to avoid a too risky situation and therefore rejected too expensive companies due to unpredictability.
What did we learn?
We have succeeded in avoiding major mistakes thanks to a systematic investment process.
We will continue to ensure that our companies maintain competitive advantages and have a clear path to growth.
In the face of too risky investment opportunities, it is better to remain humble and turn our attention to the next opportunity. The retrospective review proved to ourselves that a clear investment strategy and process guide our work and have produced the desired results.
Santeri Korpinen
CEO
