"Most market participants chase alpha but get risks, while one could chase safety and get alpha."
Based on this insight, the Scientific Investing Philosophy is focused on a "Safety First" approach. The idea is that since one is operating in a risky asset class like equities, the focus should be on reducing those risks and chasing safety. Our philosophy recognizes that a robust and cash-rich balance sheet provides the primary shield against unfavourable unknowns and powers the company to thrive on favourable unknowns that the future might throw at it. The fundamental reason behind the strong balance sheet is the persistent competitive advantage, which typically translates to strong, positive cash flows
Scientific Investing Framework
The focus of Scientific Investing can be framed as follows:
How these three objectives are met in the Scientific Investing Framework is detailed below. See the chart below too. There are companies with weak business operations and weak balance sheets. Many of these companies might be making consistent losses and negative cash flows, resulting in high debt on the balance sheets. These companies are destroying the shareholder capital, i.e., the net worth of the company. These companies are labelled as Capital Destroyers. Capital Destroyers are eliminated from the investment universe.
The next step is focusing on companies that might be showing profits and even paying taxes. However, these companies are consistently earning below the cost of capital. These companies are either at a significant competitive disadvantage, or the corporate governance is not good. In either case, these companies are eroding the shareholder capital, consequently reducing the purchasing power of the shareholder capital. The longer one stays invested in these companies, the more capital erosion. These are called Capital Eroders and are eliminated from the investment universe.
Many companies have strong balance sheets and persistent competitive advantages and are generating significantly more than the cost of capital. However, these companies are well-recognized by Mr. Market and hence are priced such that they are at a premium to their conservatively determined intrinsic value ranges. Their market prices appear justified to Mr. Market on optimistic and heroic assumptions of high margins, high returns on capital, and sizeable positive cash flows, growing at high rates for decades. If any of those optimistic assumptions becomes untrue, then the market price turns out to be too optimistic, and the price implodes. These companies are called Capital Imploders. Also, the pricing is such that even with all the assumptions working out, which is very unlikely, the investor will end up with the discount rate the market is using, which is not an alpha-generating return. These Capital Imploders are also eliminated from the investment universe.
Thus, we end up with a cleaned-up investment universe of Capital Multipliers. Capital Multipliers are companies with solid balance sheets, persistent competitive advantages, earning more than their cost of capital (on a normalized basis), and are available at a significant discount to their intrinsic values. The total portfolio returns are thus significantly enhanced since capital loss from Capital Destroyers, Capital Eroders, and Capital Imploders has been minimized. Thus, the "Enhance Safety, Enhance Returns" leg of the Scientific Investing Framework is complete.
The next step is to “Enhance Growth, Enhance Returns”. The Capital Multiplier Universe is then analyzed further to identify companies that have the opportunity to grow at high rates due to exposure to growth vectors driven by long-lasting themes, typically driven by technology, social, political, legal, economic, or environmental trends.
However, the key idea behind selecting these companies is to focus on growth vectors that are in Mr. Market’s Blind Spot. These are the companies that are exposed to below-the-radar growth vectors and become part of the SuperNormal Portfolio. Over a period of quarters to years, Mr. Market recognizes these companies or the whole growth vector. Once the companies are no longer available at a significant discount to their intrinsic values, they can be either assigned to lower weights or might be completely sold off.
Mr. Market’s Mirage is when the whole theme or growth vector is now in bubble territory, and nearly all companies are in bubble territory. This is when one has to be satisfied with the discount rate or lower.
Typically, the Scientific Investing framework would suggest buying companies participating in themes (and growth vectors) in Mr. Market’s Blind-spot and selling those companies when the theme is in Mr. Market’s Mirage.
ACMIIL designs core portfolios which provide exposure to multiple themes and growth vectors which provides another dimension of diversification and enhances the growth exposure of the portfolio.