Our flagship Mosaic Portfolio seeks to achieve long-term capital appreciation by investing in great companies at cheap prices. Gopal Gantayat, portfolio manager of Mosaic Portfolio, has nearly all of his family’s investable assets in the Mosaic Portfolio, a Spoke Fund®. Here is an slideshow about why we structured the Mosaic Portfolio as a Spoke Fund®:
Simply put, our investing philosophy is to invest in good businesses with the plan to own their stocks for years. We take a long-term, business-owner approach to investing. We buy common stock of well-managed companies that boast strong financial positions, operate in industries that we truly understand, and that are selling their stock at low prices. We look at each company’s strategy, brand, competitive position, management team, operations, and performance, etc. by performing rigorous, bottom-up analyses of SEC filings and publicly available information about the company. Although we invest with the intention of holding the stocks long-term and refraining from frequent trading, we also insist on keeping a margin of safety on all our holdings and selling any holding that we believe has far exceeded its intrinsic value.
Our Portfolio Strategy
We have fondly named our portfolio strategy “Sprinkle Cupcakes”. You can think of our approach to portfolio construction in three distinct layers — a stable cake base, a delicious icing, and colorful sprinkles.
1. “Stable Cake Base”: Stable, high quality companies
This layer forms the stable foundation of the Mosaic Portfolio. As the title suggests, it consists of relatively stable and high quality businesses. We try to stay away from traditional investing terms like “value” or “growth.” What matters more to us is that each of these businesses are high quality and relatively stable businesses. Though some pay dividends, that is not the only criteria for categorizing these as stable companies. Given the stable nature of these companies, we don’t expect them to double in a few years. But we believe that over the long-term they have great growth potential and significant competitive advantages to outpace their competitors. Over the years, these companies have generated market-beating cashflows and income for their shareholders. We are betting that for the next few years that trend of superior performance will continue and, in the long term, their stock prices will catch up to the businesses’ performance.
2. “Delicious Icing”: Disruptors, innovators and thematics
The companies in this layer make up the bulk of the Mosaic Portfolio. These include innovators, disruptors, and companies riding an emerging theme. Typically, these companies are growing faster than most of their competitors by disrupting current industry top players, innovating and creating new markets, or better executing an emerging theme. Some of these companies have been growing rapidly, changing the landscape of their industry, and in some cases, creating new industries. Others in this category are lifestyle brands that can be considered both innovators and thematic leaders. We believe this category of companies has the potential to substantially beat the market in the long run.
3. “Colorful Sprinkles”: Early stage companies, turnarounds and event-driven
Just like the sprinkles on a cupcake, these companies are the smallest layer in the Mosaic Portfolio. These include some early stage companies. The market verdict on these companies may not be clear for at least a few years. Wall Street analysts are likely to be wary of these companies because of their need to estimate/predict the stock price for the next quarter and the next year. We, with our eye on beating the market in years or decades to come, are happy to invest in these early stage, industry-transforming companies and to wait for the investment thesis to play out in coming years. The event driven investments in our portfolio are just that — investing in companies that are hammered down by market myopia due to a headline-news type negative event (oil spill, bad PR, legal troubles, etc). The last part of this layer are turnarounds — companies that stumbled in the recent past. With these companies, we are confident that the business model is not broken and that they are likely to rebound from their recent woes.
There you have it. That’s our portfolio strategy — Sprinkle Cupcakes !
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Our stock selection process has three broad criteria—high quality businesses, owner-oriented management, and compelling valuation. The following diagram summarizes these criteria that we use to build the Mosaic Portfolio.
(Note: Please click on the image if would like to see a larger view.)
1. High Quality Businesses
1.1. Technology-enabled, disruptive businesses
We love technology-enabled, disruptive companies. In the last couple of decades, the technology industry has evolved from just ecommerce websites and computer hardware and software to a strong, disruptive force in many traditional industries, e.g., retail, travel, entertainment, communication, energy, and so on. We look for innovative companies that disrupt these traditional industries or that create new industries.
1.2. Gems in out-of-favor sectors
Mr. Market’s fascination shifts from sector to sector. As you might have noticed in the weeks following the BP gulf oil spill in 2010, a lot of oil and gas drilling company stocks were down; some of that was due to legitimate risk, but many others were due to excessive fear in the market. In that kind of fearful environment, we look for gems in those out-of-favor sectors and take advantage of the opportunity to pick up stocks of quality companies at an inexpensive, fire sale price. However, we are careful and try to ensure that we don’t pick the best-run company in a “buggy-whip” industry. In other words, if the entire industry is becoming obsolete, then we are better off looking somewhere else for our investments.
1.3. Companies with sustainable, competitive advantages
More than likely, this criteria doesn’t require much explanation. I love companies with a sustainable, competitive advantage, or, as Warren Buffett puts it, companies that have a formidable moat around their businesses. These companies can maintain their pricing power and profitability for a longer time. However, it is not easy to find a business with perfect sustainable, competitive advantage. It is a subjective measure, and it changes as the market place itself changes. New technologies replace old technologies, decimating the competitive advantage of the old guard. Even though measuring sustainable, competitive advantage is not easy, we find it helpful to use this criteria when evaluating the quality of a business at a particular point in time as well as a few years forward.
1.4. Companies with high-growth potential
A lot of value investors are skeptical of high-growth companies. Not us. Profitable growth can be a good indicator of the quality of a company. Early stage, high-growth companies often present us with a great opportunity to ride the growth wave along with the company. The stock of these companies tends to be volatile. But, as a long-term investor, volatility doesn’t scare us out of high-growth potential stocks. On the contrary, the wild ups and downs give us an opportunity to buy these companies at an inexpensive price. We are not investing for a quarter or a year; we are investing for years—even decades—in the future.
1.5. Companies with favorable industry or policy trends
This criteria is the other side of the second point we previously mentioned. We like to invest in high quality companies that are riding a specific industry or policy trend. It’s an opportunistic approach to finding high quality companies. As demographics and industries evolve and policies change, we can invest profitably in high quality companies in those industries. The positive impetus of the trend can be helpful in reducing the risk of the investment.
2. Owner-oriented Management
Quality of management is one of the most important factors to consider when evaluating an investment. If the management is corrupt, the investment is lost from the moment you buy the stock. In our view, as small investors, assessing the quality of management is probably one of the hardest things to do as we don’t have extensive access to senior management of the companies. However, with the use of the Internet and publicly available information (read: Google), it is possible to investigate the management and the board of directors, etc. Here are two things I look for in management:
2.1. High inside ownership
We love companies with high inside ownership. If management has a large stake in the company, then we can rest a bit easier that management’s interests are aligned with that of outside investors like me. Of course, this thesis is not true all the time, but it is a positive for the stock. We especially like those companies where the founder is still involved in the company. Because of the lack of direct access to the management team, high inside ownership is even more relevant to small independent investors; consequently, investing in companies with high inside ownership takes care of this informational asymmetry to some extent.
2.2. Experience and execution track record
As we previously mentioned, if management is corrupt then the investment is lost right from the beginning. So, we look for management teams that are experienced and have a solid execution track record. However, I must admit that evaluating this criteria for our investments has been difficult, especially as it relates to fraud. Though a lot of information can be found in SEC filings, annual reports, and by searching on the Internet, it is not easy to detect incompetent or corrupt management. However, as long-term investors, it is important for us to keep an eye on the management before and after the investment decision.
Valuation can be a fun exercise to do. But, because of the mathematical nature of the exercise, relying too much on precise valuation may turn out to be dangerous to the investing decision. You input a few numbers and—boom!—the model spits out a number. This precise number has a psychologically comforting influence and may distort objective thinking. Valuation is mostly derived from a list of “estimations.” Therefore, it’s a rough estimate of value rather than a true value number. So, to mitigate this false comfort in valuation, we create a range of valuations with optimistic, realistic, and pessimistic projections. The following are three dimensions we keep in mind when thinking about financials and valuation of a firm:
3.1. Impeccable financial health
In general, we prefer to invest in companies with low, long-term debt. As we invest a lot in technology-enabled businesses, many of these companies do not have a substantial debt load. But, that’s not an absolute rule. A healthy level of leverage can be a good thing for return on equity. However, in turbulent times like what we have seen since 2008, a debt-free balance sheet is a good downside protection. Again, typical debt levels vary depending on the capital intensity of the industry. For example, capital goods or oil and gas companies typically have a healthy dose of debt. Apart from debt levels, we look at a variety of metrics to ensure the well-being of the companies. Some of our frequently used metrics include return on invested capital (ROIC), free cash flow (FCF) growth, margins (gross margin, operating margin, etc.), and inventory and receivable level ratios, etc.
3.2. High margin of safety
Making sure there is a high margin of safety is one of the most critical aspects of an investing decision. Seth Klarman, one of our favorite investors, wrote a book about it that sells for $1,000 in the used-books market! The profit we make on a stock depends on the price at which we buy the stock. Every investor is going to make mistakes in valuation at some point in his investing career. So, having a high margin of safety ensures that we don’t lose too much even if the original valuation was off the mark. Typically, we try to look for a buy-in price that is discounted approximately 40 percent to our weighted average valuation of the optimistic, pessimistic, and realistic scenario. However, we admit that we have bought an initial/starter stock position with less than a 40 percent margin of safety when we have found a great business that is run by top-class management and when the stock is selling at a fair price. With early-stage or high-growth companies, if we wait for the 40 percent discount to our estimated value, we may never be able to buy the stock or we might miss a large part of the price appreciation. A lot of strict value investors will be uncomfortable with this approach. However, as we mentioned before, we don’t confine ourselves in the strict value, growth, small cap or large cap category. When we find a great business, we would rather buy a starter position—maybe one-third or one-half of our target allocation—at a fair price than wait forever for a 40 to 50 percent discount. But, in most other cases, we look for a good 30 to 40 percent margin of safety.
3.3. Value of the sum of the parts greater than current price
Once in a while, the market presents us with an opportunity to buy a company at a price that is less than what its parts are worth. These are typically asset plays. In recent past, when the BP rig in the Gulf of Mexico blew up, the market pulled down the stock prices of many related and unrelated oil and gas companies. We are not a big fan of asset plays. But, during turbulent times in the market, we invest in some asset plays that can prove to be very profitable once the market returns to sane levels.
Finally, it is difficult—almost impossible—to find investments that meet all the criteria that we have listed here. Almost always, there are going to be some open questions. However, keeping these criteria in mind helps us focus our attention better on finding high quality businesses so that we can invest in them for the long-term. We rigorously work to find that right balance of characteristics and to be disciplined when making investing decisions.