Sterling Invest

Sterling Invest Alpha Process

Sterling Invest Alpha Process

  • Introduction
  • Screening
  • Research
  • Valuation Criteria
  • Portfolio Management

Sterling Invest is a, bottom-up, active investment manager with a long-term, valuation and quality driven investment philosophy. We aim to deliver maximum, risk adjusted long-term returns and to outperform comparable unit trusts or exchange traded funds.

We believe the market gives patient investors opportunities to buy shares in quality companies well below their intrinsic values. Our stock selection process helps us look for these companies from around the world, determine their fair value and dispassionately wait for attractive entry points. Upon investment, we patiently hold onto these shares for the long term and watch them grow. We only sell if we believe a company’s share price is materially overvalued, its fundamentals have deteriorated, or if its weighting exceeds our portfolio risk management threshold.

Often, the businesses we look to invest into are out of favour due to ephemeral challenges they are facing. At other times, these businesses are too small for their quality and growth potential to be perceived by the broader market and our larger peers. Because we are long term investors, we invest in these companies when they are out of favour or when they are still small at, what we believe are, attractive valuations. We believe the market richly rewards investors like us who exploit this time arbitrage and make these contrarian calls as they transition into consensus.

Our definition of risk is the probability of permanent capital loss from investing in a company. We pay equal attention to avoiding low quality companies as we do in identifying exceptional ones. This does not mean that every high-quality company is a good investment, we are very conscious of price relative to value.

Our portfolio management methodology prescribes fair diversification across businesses, geographies, sectors, themes and stock categorizations. We believe this heterogeneous strategy reduces performance volatility and ultimately, improves long term returns. 

Idea Generation
All investing starts with finding great ideas. We get ours from:

  • The general media, we are avid followers of financial markets and keep abreast with what is going on in the world:
  • Our own observations and interactions with businesses and the products and services they offer
  • Quantitative screening of our investment universe, looking for companies that score well on various financial metrics
  • Other investors who share similar investment beliefs and approaches to ours
  • A curated selection of respected sell-side research houses

 

Circle of competence
Once we have a prospective investment idea, we consider our knowledge of the company and its industry. We will not invest in a company if we believe we do not understand:

  • Its business model and how it makes money
  • The dynamics of the industry it operates in

Our research methodology entails a systematic and rigorous analysis of a company’s perceived quality and an estimate of its intrinsic fair value.

Quality Criteria

We conduct both Qualitative & Financial assessments on businesses to assess its quality prior to making any forward-looking financial forecasts used in our fair value calculations. The qualitative assessment looks at the non-financial aspects of the business whilst the financial assessment looks at the historic financial statements and formal reports of a business. The purpose of these assessments are to determine whether a business meets some or all of the characteristics we’re looking for in a quality company. The more characteristics a company meets, the higher our conviction is in investing into it.


In our qualitative assessment, these are some of the attributes we look for in a company:

  • Founder led or management materially co-invested
  • A sound capital allocation track record demonstrated by management
  • Market leader in its segment
  • Growing total addressable market
  • Many, small customers
  • Business model that is easy to understand
  • Wide and resilient moats
  • Strong balance sheet
  • Track record of sustainably growing revenues and free cash flows

 

In our financial assessment, we usually analyse the following historic metrics:

  • Revenue growth, trends and breakdowns by business segment
  • Gross profit, operating profit and net profit margin trends
  • Free cash flow growth, trends and and breakdowns by business segment
  • Balance sheet strength
  • Cash conversion
  • Capital allocation trends (dividend payouts, share buybacks, acquisitions, disposals, capital expenditures)

If a company passes through our quality criteria checks, we move on the valuation phase. There are four variables we use in our valuation methodology when analysing a business:

Normalised free cash flow during the last 12 months (F)
Free cash flow (FCF) represents the cash profits a company generates after accounting for cash outflows to support existing operations and maintain its capital assets. Free cash flow is either paid out to investors via dividends and share buybacks or is reinvested to grow the business. We estimate to the free cash flow the business is currently generating based on a detailed study of the financial statements

Annualized growth in normalised free cash flow over the next 5 years  (G)
We then forecast the growth we expect in this free cash flow over the next 5 years which enables us to estimate

The expected market multiple in 5 years (M)
We project a free cash flow multiple that we believe the market will assign to the business in 5 years’ time. This assessment takes the following into account:

-The long-term average multiple of the business itself, its peers & the broader market

-The quality of the underlying business in terms of its ability to generate reliable and sustainable free cash flows

-The growth prospects of the business

Cumulative distributions/buybacks over the next 5 years (CD)
We estimate the cumulative total of distributions we expect the business to make to investors via dividends, share buy-backs or spinning off of subsidiaries over the coming 5 years

Putting this all together, we estimate a fair value for the business 5 years into the future, using the following formula:

Fair value = (([Fx(1+G)]5 +CD)xM)
This five year forward fair value price is then compared to the current price, which provides us with an upside (or downside) percentage to fair value. We only consider investing if the company’s upside to fair value exceeds a required rate of return over the next five years.

For companies listed in emerging markets or South Africa, we target a minimum absolute return of 15% per annum (double your money over 5 years). For companies listed in developed markets, we target a minimum absolute return of 8% per annum (50% growth in hard currency over 5 years).

Concentration vs. Diversification
We believe that portfolio diversification preserves wealth but concentration builds it. We use various strategies in our portfolio management process to balance these contrasting objectives:

Concentration:

We will hold a maximum of 30 positions in the portfolio at any given time

  • We aim to overweight high conviction calls
  • We hold onto, and often add to, our winners (water the flowers)
  • Our sell discipline prescribes that we exit a position ifit becomes materially overvalued or its fundamentals have deteriorated (dig up the weeds)


Diversification:

  • We ensure the portfolio is spread across companies, industries, geographies, themes and our internally determined stock categorizations
    • Our portfolio weighting and trim disciplines ensure a single position never dominates the portfolio
    • To ensure there are no unintended bets within the portfolio, we assess the correlations of various factors within the portfolio


Correlations:
We strive to understand and reduce correlations that exist in the portfolio. Whilst impossible to eliminate completely (like during a broad market sell-off), we review correlations:

  • Among individual holdings in the portfolio
  • Of proposed new positions to be introduced to the
  • Between the portfolio as a whole and selected macro factors (currencies, interest rates etc.)