I often get asked to describe my overall investment philosophy. After many years of refinement and self-education, I’ve arrived at an approach I term simply ‘credit-based equity investing.’ That is, I try to think like a creditor, but apply that mindset to look at equities, not credit (with the odd dalliance back into bonds to be fair:)). Since lenders have extremely different, if not opposing, motivations to owners, this perspective is, I believe, at least somewhat differentiated from most stockmarket participants these days. Most all the ideas you find on this blog will be an expression of this underlying approach.
But credit-based equity investing is my chosen investing style, or paradigm; it itself however is simply an output of my core principles regarding the markets. These are four, as follows:
- You need a variant perception: if you believe that the market is mostly right, most of the time – ie, that it is semi-form efficient – and you also believe that the average market participant is highly intelligent, and competent, then by definition you need to think differently to have an edge. This doesn’t mean you need to do everything differently, but there needs to be some sliver of differentiation in how you perceive the certain parts of the market you choose to fish in.
- Best ideas only, concentrated by design: related to the above, if the market is highly competitive, it doesn’t make sense to invest in your 40th or 50th best idea – you are lucky enough to have 10+ ideas differentiated and high-conviction enough at any given time, so concentrate your capital in those. Furthermore, as an equity investor, employing leverage (as most market neutral participants will do to some extent), your cost of capital is inherently high. This high cost of capital should demand an equally high bar for deploying that capital – again, only into your best ideas.
- Market neutral – alpha not beta: this is simply more of a personal choice. I simply believe my skillset is in individual company (and sector) analysis, not in calling broader macro trends (which I consider to be extremely difficult if not unknowable). Hence, I deploy basically market neutral and rely on alpha on both sides of the book to generate absolute returns.
- Margin of safety is vital: if the macro future is extremely difficult to predict then the micro – that is, company-specific – future is highly uncertain. Hence you always need a margin of safety as a buffer for the inevitable times where you will make mistakes or something bad may happen.
My chosen paradigm – credit-based equity investing – is essentially an output that satisfies all these four core principles and provides me with the lens through which I can try to make sense of the markets and potential investment opportunities.
What is ‘credit-based equity investing’?
The below chart highlights how creditor and equity-owner motivations are juxtaposed, and also a derived framework for equity investing using a creditor mindset.
The approach is clearly rooted in Graham & Dodd-style deep value fundamental investing, with an overriding focus on sustainable free cash flow and margin of safety in the balance sheet. However I try to combine this more traditional value approach with a simultaneous focus on credit-based catalysts (on both the long and the short side of the book), as well as other catalysts to extract value without waiting around for years and years.
What do typical ideas look like?
Typical long and short ideas flow directly from this broader framework – see the below chart for the three key characteristics I look for on each side of the book. In general, good shorts will invert what I find in good longs – but with an added focus on credit-based catalysts to crystallize deep downside in a given stock.