It took a little rocket science for me to learn that investing isn’t, in fact, rocket science.
We seek out high-quality companies for our portfolios. When we study a business, we’re looking at the quality of its underlying economics. It’s tempting to make it more complex than it really is, but for me, it means focusing on companies that generate cash and then use it wisely. How did I arrive at this approach? It’s unusual, but I think my background in complex mathematics led to my simple definition of quality.
I don’t talk about my background much, but I’ve studied econometrics and mathematical finance. I’ve used something called the Kalman Filter, a system of equations that learns from itself, to build financial models. (NASA uses the same system to help land rockets accurately.) I’ve studied stochastic calculus, which, unlike regular calculus, describes something that randomly moves around, something you cannot pin down.
Early in my career, I used all the market information I could get my hands on to build models, to back test, to use data to figure out what works. I’ve got the background, and believe me, I’ve tried it. It doesn’t always work. There’s an allure to back-tested models, because you can always use the data to find patterns, but ultimately, the past cannot predict the future. The data sets may either be too short or flawed in some way.
With multiple math and finance degrees in hand and the realization that back-tested models don’t always work, I decided to focus on first principles. Does a company generate cash? Is the cash flow consistent? And can I get visibility on that cash?
What about the future?
If step one of our process is knowing a company generates cash, step two is figuring out how it will produce cash going forward. Instead of a back-tested model with a Kalman Filter-type approach, we look for something that will protect a company’s ability to generate cash in the future – a “moat.” In business terms, this is a sustainable competitive advantage of some kind, such as brand loyalty, a patent or distribution network that is difficult to replicate.
What the moat provides is confidence in the free cash flow that the company can continue to produce. We aren’t interested in reported accounting earnings but in the cash generated. From there we can make an independent assessment of the management team to determine if its priorities are aligned with ours and that it’s equipped to make good decisions about what to do with the cash.
Some companies make the decision to pay out profits as dividends, but as long-term investors, we’d prefer they also look at whether other options might make more sense – perhaps investing the money back into the business for growth or buying back shares.
What we’re looking for are companies with high returns on invested capital that can grow over time – businesses that can compound their value over the long term. In my mind, that’s quality.
Ultimately, this isn’t rocket science. It’s simple, but difficult to execute because it requires both patience and conviction. But in all my years, and despite my background in mathematics, this quality-focused approach is the only thing I’ve found that I believe can work over time.