Reflections on Hedge Fund AltaRock’s Investment Process – Part 1

On August 14, 2010, I posted hedge fund AltaRock’s mid-year letter. There is so much good information in the letter, that I thought it would be profitable to go through it carefully and post my observations. The first thing that struck me was the amount of overlap between AltaRock’s process and my investment blueprint. This is not surprising since both draw heavily upon the teachings of Buffett and Graham.

I have organized my comments using the investment blueprint, which has ten steps.

1. Search Broadly and Continually for New Investment Ideas. The AltaRock letter does not specifically talk about how they go about finding new ideas, but it does clearly define what they are looking for. If you clarify exactly what you’re looking for, you’ll save yourself a lot of time by quickly eliminating anything outside of your strike zone.

Also, alla Munger, because they have already put together a portfolio of high-quality companies in which they have conviction, they can also use their existing holdings as a benchmark when evaluating prospective investments.

2.  Act Like an Owner. Following Buffett, they view themselves as partial owners of businesses, not primarily holders of stock certificates. Why does this matter? James Montier has stated that having a long-term horizon is the most important advantage you can have over short-term speculators. In order to profit from this advantage you need to sit on your holdings for long periods of time. You won’t do this if you don’t understand the business (see point 3); you need to have the same mind-set you would have if you were buying a farm, office building, or small manufacturing plant in your home town.

AltaRock goes so far as viewing their holdings as a conglomerate, The AltaRock Conglomerate, for which they track key economic performance data. This is a good idea if it helps drive home that when you own a stock you own a piece of a real business and that your long-term fortunes, or lack thereof, will be primarily dependent on the long-term performance of the businesses you own.

3.  Only Buy Things You Understand. Massey writes that, “Successful investing involves getting to know the true nature of a business and becoming so comfortable with its characteristics and valuation that you would happily buy the entire company at today’s price with the intention of holding it for many years, if not forever.”

It is self-evident that you cannot reach this level of conviction if your don’t understand a business. Understanding a business can be defined in the more generic sense of having a deep insight into the business  – how it operates and makes money – and also in the more specific way in which Buffett uses it – having the ability to project what earnings will look like in ten years with a high level of certainty.

4.  Buy Good Businesses. AltaRock invests in companies that have a durable competitive advantage – Buffett’s moat – and that are highly profitable. They grade their holdings’ competitive position on a scale of 1 to 10. Specifically, they are looking for companies that possess some combination of economies of scale, network effect, or strong brand. See Competition Demystified by Bruce Greenwald and Judd Kahn for an in-depth treatment of these competitive advantages.

Their investments have an average profit margin of 33% vs. 6% for the S&P 500. They are not looking to beat the performance of the market by guessing, but by buying pieces of businesses that collectively have superior economics than those of the index.

They also want businesses that achieved good results without undue leverage – too much debt – and that have both a strong balance sheet and strong free cash flow. They note that their investments are producing cash flow equal to their earnings. Some businesses and industries consume far more cash than what is reported as GAAP earnings, leaving little leftover for shareholders. Over time, this is reflected in the price of the stock.

Finally, they want to invest in businesses that have a good growth platform where there is a basis for projecting growth out both 10 and 30 years.

5.  Invest in Companies with Great Management. AltaRock looks for managers who they can trust to return cash to shareholders if they cannot find additional high-return uses of capital. They judge this by looking at the long-term track record of management. Trust buy verify.

When considering an investment, go over the financials for the past ten years and see what management did with the cash. Steer clear if there is a history of poorly allocating capital, for example using undervalued shares to make an acquisition at an inflated price, or of disgorging an unfair share of the profits.

Tomorrow, I will look at AltaRock’s approach in light of the remaining five tenets my investing blueprint.


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