Beating the S&P 500 is possible

Much has been written about the challenge of beating stock market benchmarks through active investment management. Exchange Traded Funds have become increasingly popular as the solution to this perceived problem. Yet, as we note the recent 10th anniversary of Stryx America’s institutional share class on 10 July, 2017, and how this fund has comfortably produced higher returns than its benchmark, the S&P 500 index, it is worth reflecting on how this was achieved.

Ten fundamental rules have been followed systematically, rules based on common sense and designed to reduce risk and produce better results than through investing in a wide variety of businesses across the US economy. Attention is closely paid to each business and based on deep knowledge. What are these rules of quality growth investing?

Each company must enjoy a sustainable competitive advantage. This helps not only create a moat around the goods or services it offers, but will preserve this moat for a long time.

Industry leadership is key. But once achieved, this leadership will be preserved over many years, producing what is known as a long duration asset for the investor, most typically for pension funds or life insurance portfolios.

A solid financial position is fundamental. The company’s balance sheet must be largely free from debt, thereby avoiding a valuation challenge during periods of rising interest rates.

The company’s profitability will be supported by an asset-light business without need of regular capital expenditure, one that feeds upon itself.

Its underlying industry will enjoy a growth rate that is greater than that of the domestic economy as a whole. At the same time, the company must grow organically and without the need to ask shareholders for more capital on any regular basis. This also means that, on the whole, acquisitions will be frowned upon. This is particularly important in today’s economy in which money is cheap and where acquisitions appear, often wrongly, to be earnings-accretive.

Its business model will be scalable, where revenue and costs would not be linear while profit growth would be exponential. Today’s platform businesses are especially scalable and profitable where they can capitalise on a particular asset such as a brand, a distribution network or an innovative product.

Another crucial element will be the quality of management and its corporate governance. Transparency will align the interests of management with those of shareholders and remuneration of both management and staff will avoid conflicts of interest.

This transparency will extend to the company’s accounts, which will be subjected to scrutiny and thorough investigation by the investor.

The business will enjoy a wide geographic and customer diversification, thereby avoiding bulk risk.

Because these rules of engagement are fairly obvious, they will rank above the question of a company’s valuation. It is only when these conditions are met that the question arises of how much to pay for such a business. But because of the long-duration nature of such assets, the investor can afford to take an equally long term view and navigate both good and difficult times with optimism and confidence.

Over the long term, therefore, risk will have been reduced through high quality and returns enhanced through growth. A concentrated portfolio of no more than two dozen such investments will make the task of supervision manageable.

It is important that the long-term nature of pension fund and life insurance liabilities be mirrored by equally long-duration assets. The absence of such an alignment is causing fundamental problems for these industries in today’s low interest rate environment and for those who rely on future equitable distributions. If managers of quality growth businesses are able to take the long-term view, so should managers of pension funds and life insurance portfolios. It is a perfect match. That is why this approach is known as quality growth investing. And it works.

 

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