"We invest much like private equity investors would invest". February 2019


US-based investment management firm Aristotle Capital Management, LLC (Aristotle Capital) has teamed up with local funds management representative Plus Capital Management (Plus Capital) to offer its investment management capabilities to Australian institutional investors. Industry Moves speaks to Gregory Padilla, Aristotle co-portfolio manager and senior global research analyst, about the company's unique approach to managing money. He shares insights around the best questions to ask management teams before investing and why holding more than one hundred companies is not necessarily good for investors.

Why do you use a high conviction approach to global equities?

When we started investing decades ago, we believed, and still believe, the world is globalizing. Certain countries and companies have natural advantages that may persist over time.

We strongly believe that through our rigorous, independent, bottom-up fundamental analysis, we are best positioned to identify these potentially advantaged companies and expressing that view via focused, yet diversified, portfolios of high conviction companies is the optimal way to serve our clients.

What differentiates you from other global equity managers?

We view our idea generation process as a key differentiator. Unlike many of our peers, we do not use “screens” in the hope that quantitative metrics might lead us to high-quality or inexpensive companies. We find screens to be exclusionary, backward looking and can lead to “value traps”. A byproduct of not using screens is we are often “fishing in different ponds” than our peers, which can produce an uncorrelated return stream.

So instead of running screens, we spend the majority of our time studying our existing holdings and the value chains within which they compete. In doing so, we learn more about not only our current investments, but also the companies in their respective value chains. Often times this continuous understanding of existing holdings leads us to other unique companies that may be purchased in the portfolio.

Thinking formulaically or linearly typically results in ordinary outcomes. By studying businesses in differentiated fashions, we can find unique businesses in otherwise ordinary places for most – our existing holdings.

In addition, while many of our peers also believe in the merits of a fundamental, research-oriented approach, we differentiate ourselves with a highly focused, yet diversified, portfolio (~50 holdings) that we believe allows us to fully benefit from our research and drive value for clients through security selection. An overly diversified portfolio (hundreds of holdings and small position sizes) would inhibit our ability to earn a “fair return on our mindshare.”

What is appealing about your offer and approach for Australian investors?

Our approach is predicated on owning what we believe to be unique companies, with attributes that may not be widely recognized by others, and holding these durable franchises for the long term.

We do not attempt to produce maximum returns every quarter or every year. Our process is designed to generate optimal results over time. For us, process is more important than any individual result. We reward our team, over time, for a process well done, such as a business model better understood, not for a “stock” well “picked”. A stock pick is fleeting; a process may stand the test of time. Our view is that investment results are the proof statement of a process well executed.

Our discipline and commitment to our process has been, and we believe will continue to be, instrumental in yielding a consistent and repeatable output. Focusing on the quality of our inputs (the process) is, we believe, the best way we can produce an optimal output (results).

We reward our team, over time, for a process well done, such as a business model better understood, not for a “stock” well “picked”

You’ve described your style as a private equity approach to public markets. Can you expand on this?

We invest much like private equity investors would invest. While short-term investors merely rent the stock, we are long-term investors buying a piece of the business. Unlike a private equity firm, however, we will not take an active role in managing the businesses of the stocks we purchase.

Our process can be thought of as a three-legged stool with Quality-Valuation-Catalysts each acting as a “leg”. Similar to private equity firms, we start by identifying whether or not the business is one we’d want to own in its entirety for a full market cycle.Focusing on the business quality first and foremost, enables us focus on a more narrow and static universe that typically provides more downside protection.

Again, much like a private equity investor would, we value the business as if we were to buy the entire company, not just the stock. We then value it based on cash earnings, under a “normal” scenario. We care little about accounting earnings and instead focus on cash flows generated for owners of the business.

The last leg of our stool is catalysts. We define catalysts as an action or event currently underway that management has control over. Catalysts must be company specific and are what we believe will propel a company to meet its full potential within the next three to five years.

Does this mean there is low turnover in the portfolio?

A philosophy of thorough analysis and selective action has led us to hold relatively few positions and maintain a low turnover rate (typically 20-30%, although it has been lower in recent years). We employ a three- to five-year time horizon when determining the attractiveness of an individual security. We believe that this time frame is optimal relative to our investment approach, as it provides adequate time for the catalysts we have identified to be realized, thus closing the gap between our initial cost and our determination of the company’s intrinsic value.

Are company visits an important part of the investment process?

A significant portion of our initial and on-going company research is conducted “in the field.” Members of the research team meet with company management in their offices, in our offices and at industry conferences. This includes companies for prospective investment as well as their competitors and others in the value chain. Such activity is critical to our investment process and can be leveraged to gain a deep understanding of industry dynamics and the key players within a given industry that can impact portfolio holdings.

Simple questions like “What keeps you up at night?” or “Which competitors do you most admire?”, can, and sometimes do, lead us to new investments. We’re more interested in what a management team is doing today that will bear fruit in three to five years. What are the strategic decisions they’re making today that will propel the company forward?

Simple questions like “What keeps you up at night?” or “Which competitors do you most admire?”, can, and sometimes do, lead us to new investments.

What do you love about your industry?

We love working together to help everyone, particularly our clients, succeed. We are blessed to be in an industry in which our personal and professional lives are closely intertwined. Some of us have been together for multiple decades in a couple of different iterations of the business. It is a testament of the enjoyableness of the workplace. One of the beauties of the boutique environment that we are fortunate to be a part of is that, while we meet formally, we also spend a lot of time informally just talking about companies. We have tried to cultivate a very curious, collaborative and collegial environment at Aristotle. We love what we do, and we are self-motivated. This industry also allows for self-reflection and a willingness to learn from our success, as well as our failures.

What don’t you love and what do you wish you could change about the industry?

It seems to us that our industry is increasingly short-term focused. There are fewer folks focused on the long-term. With management teams, this of course is a shame, but with our competitors, this can be an advantage. As more of our peers focus on the noise that is so prevalent in the market, we believe this provides us an opportunity to further distinguish ourselves by focusing on the fundamentals of individual companies.

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