How to identify "low risk multibaggers"
My investment philosophy and how I identify "low risk multibaggers"
Introduction
I wish there was an easy way to describe my investment philosophy. Looking at my highest conviction bets, they are all made out of different reasons, which you will come to read in my future write-ups. I have read numerous books on investing, listened to countless podcasts and talked to many different types of investors representing the full investment universe from venture capital, private credit, special situations in private markets, private equity, quantitative strategies and hedge funds. In addition to reading and listening, I have also practiced early/growth stage investing at a venture capital firm and conducted M&A due diligence for different types of investors as my full time job for 5 years since coming out of my Master's degree in Business and Finance.
I believe the sum of all of this is one of my biggest strengths as an investor. I am style agnostic and view my investment philosophy as a combination of the best that each strategy has to offer.
However, I believe the following principles to be the cornerstone of how I think about investments (in its simplest form):
1. Simplicity
The investment thesis should be simple to understand and communicate. I find the simplest investment thesis to be the most successful. I use first principles rather than drowning in information and over-analyzing, which more often than not will hurt your returns. If the thesis is not simple to understand, it's probably not obvious enough.
2. Predictability
I invest in companies with predictable revenues and earnings. The predictability can come from various reasons: You know the industry and company very well, the company has a strong brand and long history of consistent revenues, the company has long contracts with its customers, government/regulations are a significant driver of demand or high share of recurring revenue are concrete examples (where one does not exclude the other).
3. Sales growth
I like sales growth to be the cornerstone of my thesis. At the end of the day we are all looking for multibaggers. Most multibaggers are driven by sales growth. I also find sales growth easier to predict and track, rather than operational improvement/margin expansion theses. For sales growth to happen, there needs to be an end market which is big enough and/or growing at a rapid pace, which is why I often look for that to support my sales growth thesis.
4. High profit margins
I actively chase companies with profit margins. Translated, high profit margins indicate two things: 1) There is high perceived customer product value (i.e. customers are willing to pay you a lot more than it costs you to produce the product) and 2) It's difficult or impossible to get that service from somebody else, meaning you are competitively advantaged in the market you are currently serving.
5. (Relatively) Low capital intensity
It's really easy. Capital intensity does not have to be extremely low on an absolute basis, but it has to be low relative to profits. High profit margins + low capital intensity = High returns on capital = High cash returns to shareholders. Which is what we are all searching for.
6. Sui generis
A lot of investor's talk about moat or competitive advantage. The goal is to assess whether profit margins and returns on capital are sustainable. Figuring out whether a company has a sustainable competitive advantage is very difficult (business history will show you this). Especially for microcaps, since many types of competitive advantages are formed over time (i.e. with increasing scale or brand building). I therefore like to frame it differently: Which companies are 'sui generis' - Unique, one of a kind. I like investing in companies which are different from everyone else. There might be competitors in both core and adjacent markets, but there must be something about the investment prospect which makes it stand out from the rest in a way that is not easy to copy.
I love this quote from Peter Thiel in 'Zero to One':
“Tolstoy opens Anna Karenina by observing: “All happy families are alike; each unhappy family is unhappy in its own way.” Business is the opposite. All happy companies are different: each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition.”
7. Outstanding Management
Another obvious one. Management has to be of outstanding quality. I want them to be intelligent with high integrity, excellent operators, shareholder friendly and great capital allocators. Not an easy ask, and some of these characteristics are not easy to measure. It's one of those "you see it when you see it." My latest example of this is Dustin Haw at TerraVest Industries, who checks every one of these boxes.
8. Price
Of course. At the end of the day it all boils down to valuation and margin of safety. Like Seth Klarman says: "What happens when you are wrong is everything in investing."
I am OK paying up for high quality and growth, but it is vital that the business characteristics and price align in such a way that there is limited downside in the stock should my investment theses be wrong. At the end of the day, we are all making qualified and informed bets and want to limit the downside of those bets. Asymmetric return profiles is the holy grail in investing.
9. My only holding period is ‘forever’
I want to quote a tweet written by the Twitter user Sidecar Investor:
“I intend to own every business forever.
This is not hyperbole.
Some will get taken out. I’ll make mistakes and some will be sold for more attractive opportunities.
But buying with the *intent* to hold forever focuses of mind on what is truly important.”
Holding ‘forever’ focuses the mind. In addition to that, I find that it mitigates potential biases. Drawdowns are part of the journey of multibaggers. Experiencing market volatility might cause you to sell in an emotional state, in which case you will never be able to experience the joy of holding on to multibaggers. Besides, timing the market is impossible. I find that keeping a ‘forever mindset’ keeps my biases at bay. I am also constrained by my full time job. I can’t keep an eye on the market and act on movements 24/7.
Therefore, I never invest in companies where the whole thesis is based on one near term catalyst with no future prospects, or some extremely cheap shitco which according to me should be rerated. No cigar butts for me.
Conclusion
The combination of these characteristics is the making of a 'low-risk multibagger'. I will be the first one to admit: There is nothing revolutionary here. I believe my differentiation as an investor is my ability to assess these characteristics and figure out which companies truly encompass them. That mixed together with a concentrated portfolio of a few names, a high investing standard (with my current high conviction bets as my benchmark when assessing new opportunities) and patience get me there.
If I can find an investment opportunity which has a combination of these characteristics, I get very excited. I am not constrained by company size, but I find smaller companies and depressed markets to more often possess all of these characteristics rather than big companies and flourishing markets.
Again, the rational underpinning my conviction might be very different and they have to be evaluated on a case by case basis, which you will see in my future write-ups - Especially on point 8) Price. There is no formula enabling you to easily check every box. But hopefully, by reading my write-ups, you will learn how I think about these things and evaluate them in different settings.
H Capital Investing