Pennsylvania Trust Company’s Multi-Cap Value Strategy invests in a select number of financially-strong, highly-profitable companies that we believe based on our research can consistently compound shareholders’ capital at high rates over a multi-year time-frame. The Strategy seeks to outperform the S&P 500 over the course of a full economic cycle by capturing most or all of the benchmark’s returns during the market’s up periods and losing less than the benchmark during down periods.
History shows that an investor’s return from a stock will, when held for the long run, approximate the growth in shareholders’ capital of the business which underlies it. This growth rate is determined by the return that management generates from reinvesting the company’s excess cash back into the business. Those companies that can consistently reinvest shareholders’ capital at above-average rates of return should see similarly high increases in their share prices over extended periods. This is the essence of compounding, which Einstein famously called “the eighth wonder of the world.”
By the same token, the greatest obstacle to superior investment performance is the time spent recouping sizable capital losses, as it is time that, by definition, cannot be used for capital growth. Experience has shown us that a carefully-selected portfolio of extraordinary businesses faces less risk of capital loss than the major stock market averages, which are widely populated with lesser-quality companies whose long-term profitability is lower and much less certain.
Given the lengthy time horizon for our investments, our definition of value relies more upon our assessment of the long-term economics, durability, and management quality of the business under consideration than on the current market price of its shares. We believe that exceptionally profitable companies deserve to trade at above-average valuations. At the same time, we are unwilling to pay a high price that is likely to undermine a company’s expected long-term returns to shareholders.
The Strategy invests in the common stock of companies that:
- generate above-average returns on shareholders’ capital;
- reinvest excess cash flow back into the enterprise at comparably high returns; and
- require low levels of maintenance capital expenditure to grow.
Our investment selection process considers both quantitative and qualitative factors. First, we screen for financially-solid companies that have track records of sustainable, profitable growth as reflected by high returns on invested capital, stable to improving margins, and steadily increasing free cash flow, among other things. Second, we look for signs of lasting competitive advantage(s) that indicate this high level of profitability can continue far into the future. These advantages may include:
- exceptional pricing power;
- growing economies of scale;
- limited competition and significant barriers to entry;
- high customer-switching costs;
- a digital platform with strong network effects;
- valuable trademarks, patents, and other intellectual property;
- an increasing percentage of recurring revenues; and
- a large and expanding market opportunity.
We believe an advantage of the Strategy is that it restricts our focus only to great businesses. Consistently strong returns on invested capital almost invariably result in high-quality earnings, comprised mostly or entirely of free cash flow. We have found that these companies are typically led by talented management teams with strong capital allocation skills and the necessary discipline to manage long-term growth successfully. The best managers treat outside shareholders as partners, which is not surprising given that many of them are also significant shareholders in their own right.
The number of stocks that meet our investment requirements is necessarily limited. Most companies can be quickly eliminated from consideration owing to an insufficient track record of profitability, a history of poor management decisions, an over-leveraged balance sheet, and/or the presence of widespread competition. Our investment universe today consists of about 100 to 125 stocks.
The Strategy typically holds between 20 to 30 stocks across a broad spectrum of market capitalizations (small, mid, large, mega). Individual position sizes range between 1.5% and 10%. As measured by portfolio beta and downside capture, among other things, the Strategy is designed to deliver lower negative volatility than the stock market as a whole.
Sector weightings often vary greatly from the benchmark. Some sectors, such as energy, telecommunications, and utilities, will have little or no representation due to their inherent cyclicality and low levels of profitability. We believe our concentrated, non-correlated approach, which emphasizes superior stock selection and overweights our highest-conviction ideas, increases the Strategy’s expected risk-adjusted returns and the potential for outperforming the benchmark over the long run.
All clients are individually invested in the Strategy’s holdings in separately-titled accounts. We do not use pooled funds of any kind. We eschew the idea of automatic full investment, opting instead to deploy investor capital only when we can find qualifying investments at reasonable prices.
High-quality businesses are hard to find, and thus they should rarely, if ever, be sold. We never use target prices for selling stocks in the Strategy. We will only sell a stock if we conclude that:
- our original basis for investment has been undermined, which most often occurs when a company’s profitability, as measured by its long-term returns on capital, has been permanently impaired;
- it trades at such a large premium to our estimate of intrinsic value that its expected long-term returns are no longer attractive;
- management has lost the ability to run the company successfully and/or has demonstrated an unwillingness to act in the best interest of outside shareholders; or
- a superior investment alternative has become available.