Investment Philosophy
Free cash flow is key to the investment process; what management of the company does with that cash is less important. Dividends, stock buybacks or simply plowing the cash back into organic growth are all acceptable, as the pair say they trust the management of the firms they invest in.
“We don’t have any black box or supercomputer that tells us when to buy something. We’ll look at basic methods like price-to-earnings, but we’ll also look at enterprise value to free cash flow,” Bousada says. “There’s nothing untraditional about our evaluation metrics at all. We’re not trying to reinvent how to value businesses.”
Their investment process is focused on two elements: risk and growth, although they say their approach to each differs from the rest of the market.
“The vast majority of the market defines risk as volatility,” Bousada says. “We think that’s the wrong definition. We define risk as the opportunity for permanent loss of capital.”
An archetypal example of this might be the 55-year-old investor who, in 2000, feels he is being left behind by the dot-com boom. He shifts his assets into the tech sector just before it collapses.
“You just experienced permanent loss of capital. After you do that, you’ll not make your money back, after accounting for inflation,” Bousada says.
That example is not as isolated as it might sound. Similar bubbles burst on a regular basis: in the 1970s, it was oil; in the 1980s, Japan; the early 1990s, emerging markets; late 1990s, technology. In the 2000s, the bubble was real estate, for much of the developed world.
“We approach each business as if it’s a business that’s going to feed our family and put a roof over our head,” he says. In the case of EdgePoint’s staff, that’s literally true. “The majority if our worth is tied up in the portfolios. If you work at EdgePoint you have to own the portfolios.
“When you approach risk in that fashion you’re looking at different types of risk.”
Among the risks they watch for are those that can affect revenue growth and margins, management succession, barriers to entry, and “the risk of not knowing what you’re doing.”
Says Bousada, “The last one is probably the toughest one to wrap your arms around, but it is legitimately the one that has kept us out of the most trouble over time.”
Throughout their careers, he says the pair have steered clear of once marquee names that have later blown up.
“Were we smart enough to know they were all going to go to zero? Absolutely not,” Bousada say. “We took a look at AIG when the share price was cut in half, thinking there might be an opportunity. But the reality was, you look at the annual report and it doesn’t take long to realize you don’t know what’s going on inside that business and you don’t want to own it.”
The EdgePoint Canadian Equity Fund is a concentrated portfolio of between 30 and 50 of “feed your family” companies, but there are no mandated constraints on the portfolio sizes, MacDonald says. In the past, the Canadian fund has included as many as 60 names. The Global fund tends to range between 25 and 40.
“Once you start getting up in the high 30s or 40s, more often than not, [companies] 1, 2, 3, 4, 5, 6, 7 [are the] best ideas in the fund [and] just blow the socks off the 40th,” he says. “You just stare at the 40th best idea, day in, day out, comparing it to even your 15th [best idea]. And eventually you come to the realization there’s no comparison. So it’s really hard to get above 40 names.”
Neither the Global nor the Canadian mandate has capitalization constraints, but smaller-cap names are rare within the global fund. MacDonald says they are more comfortable with Canadian small-cap stocks because they are able to meet with management teams more frequently.
With an eye toward buying growth at a discount, Bousada says he would be comfortable with a substantial cash position. But this has never risen above 15% in his career, he says, because there has usually been an opportunity at hand.
“If a 5% name gets taken out of the portfolio, it’s in cash,” Bousada says. “We are not compelled, within the next day or the next week, to find an investment. The cash range is fixed on finding opportunity to make people money without taking silly risks.”
On the Global fund, it’s easier to find a company to replace the one sold from the portfolio, so cash is usually redeployed more quickly. Again, the absence of constraints helps.
“If you’re living in just big-cap-land and your universe is 400 companies, then there will be periods when you might get extremely uncomfortable being invested,” says Macdonald. “You can go over the universe every 30 days and stare at it and just say I don’t feel comfortable.”
For more on EdgePoint’s target market, history and view on ETFs, see the September issue of Advisor’s Edge Report.
