How to invest in public markets with private equity mindset?

Investing, be it through private equity or public equity, in the end comes down to owning the right businesses. The core fundamentals and principles in evaluating these businesses are inherently the same. Be it in private equity or public equity, one must remain firmly committed to the investment philosophy of backing outstanding management teams spearheading incredible businesses that have the ability to compound capital over a long period of time.

The investment philosophy could be built on three pillars – stellar people, incredible businesses, and time.

1. Stellar People– Given the accelerating pace of innovation, backing superb management teams becomes very critical. Management actions in the face of disruption will play a critical part in preserving, widening, or destroying the company’s competitive advantages. Quality of management is one of the most important criteria in investment philosophy. It is critical to assess certain softer elements related to management teams – their motivation, commitment towards building a truly differentiated organization, their fit within the culture of the firm and ultimately, their alignment of interest with long term shareholders. Short term pain is often a price to pay for long term gain and is a management virtue that greatly resonates with us.

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2. Incredible Business – These are businesses that have a competitive advantage that can be sustained over a long period of time, and thereby enable the company to generate high return on capital which is significantly above cost of capital. This would lead to significant shareholder value over a period. These businesses typically demonstrate strong bargaining power over their suppliers or customers, which enables them to earn superior margins. This advantage could be driven through being the lowest cost, albeit best quality producer for a B2B business or having a strong brand name in the case of a B2C business.

These businesses either have a dominant market share that enables economies of scale or are gaining disproportionate market share due to an innovative product or a differentiated distribution set up. Thereby, they garner a majority of the profit pool of that industry, making it difficult for incumbents to enter. They have a history of efficient capital allocation and balance sheet discipline. As a result of this, these companies could deliver financial outperformance through economic cycles.

3. Time – What amplifies value creation from an incredible business run by a strong management team is the potential for longevity of profitable growth. To harness the power of compounding, it’s best to focus on low churn in the portfolio. Thinking long term is a big competitive advantage in the public investing industry. One needs to take a step back and understand the size of opportunity and the company’s ability to take advantage of this, ignoring short term noise and whether the quarter will be a beat or a miss. The focus is on buying businesses with a long runway for growth, as demonstrated by sustained earnings growth of >20%.

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These could be companies that have a dominant position in industries which are at a nascent stage in their life cycle and thereby are well positioned to grow alongside the industry. Alternatively, the business could have a small market share in a large industry, but is very well positioned to gain market share over several years due to its competitive advantages. Recurring revenue streams and platform businesses are some key attributes that one must look for. Certainty of high long-term growth helps immensely in correcting potential valuation mistakes. While valuations can have a large impact on stock performance in the short term, in the long run, stock performance will revert to the underlying earnings growth of the business.

Risks

One of the key differences between private equity and public equity is the availability of liquidity. This can be a double-edged sword. While it can help you cut your losses in investments that were a mistake, it can also encourage short-term thinking and an impatient mindset – something that one must actively guard against. While one needs to avoid complacency and stay vigilant on exiting companies at the right time to avoid mistakes, they must also ensure that they are not being trigger happy and exiting positions on the first sign of trouble, which would prevent reaping the great benefits that come from steadily compounding capital over a long period of time.

There are three main reasons to exit an investment:

Change in fundamentals – Distinguishing between a genuine change in the underlying fundamentals of a company versus noise is what makes this style of investing so challenging. Over several years of investing, we have realized that there are only a handful of variables that truly matter in a company. Those are tracked very actively for any significant change that warrants to exit the position.

Excessive valuation –If one doesn’t see the upside potential from holding a stock over a 5-year time after assuming healthy valuation multiples to future earnings, they could consider exiting the position. One caveat here is that opportunities to invest in great companies run by incredible management are few and far in between. Therefore, the bar to exit, as far as valuations are concerned, should be deservedly high.

Better opportunity – The knowledge base on a portfolio company moves up dramatically as time progresses from the initial investment. As a result, the threshold to replace an existing investment with a better opportunity is quite high for some.

By being true to this investment philosophy, keeping a vigilant eye on developing risks and being disciplined in the criteria to exit, the probability of compounding capital at a healthy pace over the long term can be maximized.

(By Hardik Doshi, WealthBasket Curator & Fund Manager at White Whale Partners)

Disclaimer: White Whale Partners is a SEBI-registered portfolio manager. Investments in securities are subject to market risks. Read all the documents or product details carefully before investing.