Analysis from Stuart Widdowson, Portfolio Manager at Odyssean Investment Trust PLC
Private equity investing can often seem a dense and inaccessible sector in the world of finance, yet its commitment to stock selection and improving returns holds lessons for us all. We believe that adopting a ‘PE’ mindset can reap real benefits even for those investing in public markets.
Behaving like a private equity investor requires a long-term investment horizon, highly focused stock selection criteria, thorough fundamental analysis, and a deep understanding of a company and the market it operates in. Strong private equity investors can unlock great value in companies by spotting the potential to improve financial returns or grow more than is thought possible. They also focus on making money over the long term, rather than aiming to beat an index in the short term.
Adopting a private equity mindset even when investing in public companies is a way of improving our ability to see solutions rather than problems and uncover long term opportunities for improved returns that others may miss or avoid. We believe that this method can be particularly effective when investing in smaller companies. Focusing on the fundamental opportunity for a company to improve returns through self-help rather than any reliance on the macroeconomic backdrop or performance of wider markets has real advantages in securing a differentiated source of attractive returns and building a resilient portfolio.
A three-pronged approach
From the Odyssean team’s considerable private equity experience, we have found that three key metrics are important to consider when looking to adopt the PE mindset to investing in public companies: valuation, quality, and engagement.
On valuation, we are not deep value investors seeking “cheap” stocks. Rather we seek out good companies where the current market value is reasonable, or even better falls below its intrinsic value, and where there is clear potential for that intrinsic value to be enhanced.
To do this, knowledge of the private equity space, and what a private equity investor or potential trade acquirer would look for when buying a company can provide key insights. As well as entry valuations being below intrinsic value we seek opportunities for this intrinsic value to grow over three to five years. We are looking for sales growth, solid cash flow, the potential to improve margins, and the chance add value via M&A. Any re-rating above these four factors adds another leg to potential shareholder value growth. The approach encourages a long-term mindset, looking beyond monthly or quarterly earnings reports and to the future opportunity for shareholder value growth over several years.
It also encourages a focus on quality. By delving deep into the fundamental characteristics of a business, our team applies a private equity style approach to public companies using rigorous, in house research to uncover opportunities and threats to the business model, subsequently deciding whether the underlying business is of a high enough quality. Our litmus test: if we would not be a happy owner of 100% of a business, it does not get into our portfolio.
We particularly like market leaders in a niche market which are generating returns below the average of their peers, as the market leader should rationally be making higher margins and be a more covetable business. Moreover, we like opportunities where focused engagement as a knowledgeable investor can support and challenge a management team on sustainably improving long term returns.
This latter point is key. For a company to truly stand out its leaders must be open to engagement and change. As investors, we ask if a company could do better, and look at how it can best use its resources and enhance its offering. Without a management team that is open to engaging this approach is unlikely to work.
A prime example of this approach working in practice was Odyssean’s first investment – SDL, a global market leader in providing translation software services and technology. It had a good, recurring, business model and a reasonable valuation based on its existing financial performance. However, through our deep, fundamental analysis and due diligence we recognised that margins were not as high as they could be and efficiencies could be made. The business had grown quickly, but there was considerable scope for the business to generate better returns from its existing resources. The risk/reward case was compelling, with little of the potential margin upside in the valuation when we invested, no balance sheet risk, a management team with a credible plan and a highly covetable market position and IP. There were no poison pills for any potential trade or private equity acquirer. We believed that either the team would execute the improvement, or the company would likely attract interest from suitors. Ultimately part way through the improvement plan the company did attract a highly attractive bid from a trade peer.
This example demonstrates why ours is a method that needs patience and the ability to follow through on long-term plans, both of which are enabled by opting to work within an investment trust structure. With a permanent pool of capital to draw on via our closed ended investment company, there is no need to sell holdings to meet redemptions. This means the team can behave as committed, engaged and patient long-term investors.
Importantly, adopting a private equity mindset is not about buying shares in the aim of encouraging a buy-out of the company, which may be a mainstream perception of the sector. It is in fact more an understanding what kind of firm makes an attractive opportunity for investors and applying the tools and methods of the PE sphere that can help do just that. The goal – make money for our investors and generating attractive balanced returns, without taking on too much risk. In an increasingly competitive world where style can often trump substance, opting for a new and different approach to investments is what will really help you stand out from the crowd and create a resilient portfolio built for the future.