Our investments must meet specific criteria of our defined investment philosophy incorporating elements of growth, quality and control of risk. More than a few of our positions are initiated at times when sentiment surrounding a company is negative, because we feel this provides an opportunity for intensive research to be most productive. Moreover, such moments can set up an entry point when profits are temporarily low or below trend, which simultaneously creates a valuation discount to where earnings might grow towards the end of our investment horizon.
We typically develop detailed financial models to help us understand what makes a company tick, especially when there are multiple segments or product lines within segments, which are based upon templates developed in house for over three decades. However, ultimately discussions with managements and competitors, often face-to-face, and extensive digging helps Gaineswood form an opinion about quality, competition, growth potential, and risk.
Since our inception, we have used our proprietary growth-value matrix that classifies stocks into two sets of quintiles that we think helps us avoid falling into “value- or garp- traps,” which we think arise when sellers possessing deep knowledge have driven shares below historical bands of valuation. The matrix keys in on per share profit and growth expected two to three years out compared to recent earnings, rather than the common approach of establishing valuation compared to near-term forecasts and historical growth rates. We believe the matrix helps enhance our patience in screening out contrarian situations that have not yet had enough time for negatives to play out, because to have a low base year from which growth rates can be reset, by definition at least four quarters must pass by.
However, we’re ever mindful that no matter how much research we do, even we might not have clarity to see black swans that might be flying beyond the skyline. The matrix can place stocks into falsely enticing quintiles due to imperfect knowledge, but at least we feel this might happen after many negatives have been priced into a situation already. Conversely, it can fail to identify value based upon undershooting out-year earnings potential, or opportunities that are just beyond the time cutoff. For this reason, we sometimes engage our qualitative override. We may stick with some tough situations, but we may wait a year or two before rebalancing. The matrix is just a tool, and we are foremost deeply fundamental original researchers, and secondarily we introduce quantitative tools.