June 2019 - At AMI, our investment process consists of methods that are based on the collective experience of our team, some of whom have worked in the investment industry for decades. While there is always debate over whether or not “this time is different”, there are certain tenets of investing that seem to be true through all cycles. Including the following in our fundamental research process has helped AMI to construct quality portfolios that have historically performed well.
• Focus on what people and businesses use and can’t do without and you’ll find a great business. Many years ago, AMI’s founder stumbled across a box of Arm & Hammer backing soda which ultimately led him to investigate the company which produced it. It occurred to him that every refrigerator in America likely has one of these boxes in it. The company’s manufacturer, Church & Dwight (CHD), turned out to own many other great brands and had quality earnings growth. It was one of the first large positions at AMI and we still own the stock today. Sometimes, companies like this are not found through quant screen but by actually seeing what is moving on store shelves or what executives we talk to are constantly worried about (internet security, transportation, etc.). On some level, when we are looking at a potential investment we seek to talk to the everyday users of the product or service and try and get their honest opinion and see if there is just no substitute.
• Recurring revenue drives long term wealth gains. Recurring revenue has grown to become a big buzzword in financial circles as it often comes with a higher valuation. AMI has been focused on owning recurring revenue growth companies since its inception in the 1990s and is a major part of our DNA. Essentially, beyond traditional subscription businesses we view “recurring” as companies whose products and services are needed regardless of economic conditions. Becton Dickinson (BDX) is a great example of this, with its highly consumable medical supplies that are turned over frequently. Sectors such as Consumer Staples and Healthcare are natural fits for our strategy, as recurring revenue companies are more prevalent in these areas, and it is one of the reasons that we overweight them in our portfolios. These sectors tend to perform well during boom periods, but also hold up better than more cyclical areas during economic downturns. Our focus on these types of companies has not changed over the years. The investable universe has actually expanded now that more companies (like many software companies) are embracing recurring revenue business models.
• Downside protection is built into our philosophy. We are often asked about our risk controls and methods. While we employ several risk management methods, our main risk control is our investment philosophy. Timing the markets can be difficult; to mitigate risk we believe our investment philosophy of owning high quality companies at reasonable valuations that have recurring revenue business models serves as a natural hedge when economic downturns arrive. To be clear, our strategy is not defensive. In fact, our portfolios have earnings growth numbers that are, on average, in line (or better) with their growth benchmarks. That being said, because of our philosophy, we strive to preserve capital during downturns in the market, while keeping pace during bull markets.
• Earnings and cash flows are of upmost importance. AMI has always been focused on owning high-quality companies that have a consistent track record of producing positive earnings and strong cash flows. We also prefer companies that are not highly leveraged. These companies can suffer during tough economic periods like we saw in 2008-2009, when they had difficulty refinancing their debt at attractive rates. This sounds simple enough, but money managers can easily be lured into flashy (but grossly unprofitable) names that will severely underperform in downturns. Our mission will always be to find these high-quality businesses that are both profitable and growing.
• Ignore the noise. Politics has increasingly become an everyday topic in the business world over the past few years. To a large degree it is understandable- we have a trade war with China (and now possibly Mexico), tariff threats, changing tax policy and other items that are likely to be politically motivated. At AMI, while we pay close attention to anything that may impact our portfolio holdings, our view is always focused on the long term. Political winds shift every few years and we will look to short term dislocations as opportunities rather than challenges. An example would be Healthcare companies during the Obama administration and how that conversation has changed over the years. A highly politicized fight over the passage of the Affordable Care Act has now led to an attempted reversal under Trump. Healthcare stocks have been whipsawed throughout this period, but the quality, growing companies in that sector have endured and our focus is to find companies that can grow in any Healthcare environment. There may be additional, divisive issues that may arise under the next administration, but we believe by ignoring the noise and focusing on long term drivers of value is what leads to long-term wealth creation.
• Pay attention to capital allocation. We firmly believe that a company should have a well-articulated capital allocation program. While not all of our investments pay dividends or have share buyback program, we generally have a preference for companies that have shown to be good stewards of shareholder capital. Historically, we’ve seen that management teams become more disciplined in their budgeting process when they communicate a clear capital allocation program, especially when they have committed to pay dividends or repurchase a certain amount of shares over time. This tends to lead to a more disciplined approach toward M&A, capex, and spending which is an infamous source of value destruction. Not only does a strong and committed capital allocation policy keep management teams disciplined, it has the additional benefit of increasing total returns for shareholders. While this may not be true in all cases, more often than not, a management team with a disciplined approach toward capital allocation will lead to a healthier company in the long run. This dynamic is evident in a company like General Electric. It wasn’t until management deviated from its dividend growth policy by becoming an overspending, M&A machine, that it ran into serious financial difficulties.
While it’s important to look at all of the fundamentals of a company and keep an eye on the economic environment, we feel placing an emphasis on the above process has led to quality security selection in the past. We realize that there are many factors that will impact the prospects for any company, however we believe that using the above as a foundation of our investment process will help us to uncover the highest quality opportunities going forward.