One of the principal changes we made to our investment strategy during the year was to prioritize searching for businesses that can double in size in the next 5 years (i.e., compound machines) instead of searching for investments that have the potential to double in value in the next 5 years (i.e., opportunistic investments).  In other words, instead of having our investment strategy be centered on buying businesses at a large discount to their underlying value we are now more interested in buying growing businesses that can double in size at a fair value.  A good analogy is we are changing from investing in diseased mature trees that should get better after treatment to investing in healthy saplings.  Don’t worry, we are not abandoning our value investing roots.  We continue to believe the price we pay for an investment is the most important factor we control and is what determines our future rate of return.

Our losses in Aéropostale prompted us to examine our historical investment record in opportunistic businesses (those that trade at a large discount to value and have low growth potential).  We learned even though some of our highest returns were from opportunistic investments, our performance was below average when we considered our losses and permanent capital losses such as with retailer Body Central.  In other words, even though we hit some homeruns we ended up playing a bad game which hurt our overall results.  The key lesson is the overall compounding of our capital was negatively impacted by our losses in the opportunistic investments.

Alternatively, when we examined our compound machine investments our worst was Strayer Education where we lost on average 30 percent of our original investment.  What explains the disparity in results from these two different investment strategies?  With opportunistic holdings we are often invested in falling knives or businesses that risk bankruptcy due to large amounts of debt, high fixed costs or turnaround situations.  In contrast, our greatest risk in compound machine investments is that we may misjudge the growth prospects of the business and potentially overpay for growth that does not materialize.  In this type of scenario we would typically only lose a portion of our investment instead of our entire investment.

We find the discipline of only seeking growing businesses to be not only a safer strategy, but a more interesting one.  We aren’t spending time worrying about whether a business will survive or get the same credit terms from a lender.  Instead, we can focus intently on finding solid management that is building great products and services.

The Growth Mindset

There are a few adjustments we are making to our overall investment process that we have successfully applied to investing in growth businesses in the past.  First, we need to focus on how we think about valuation as many of these growing businesses are either losing money or under-earning relative to their potential as they reinvest in their own growth.  This requires some adjustment in our search process as we look for businesses trading at a multiple of revenues instead of a discount to revenue or cash flows.  As a friend Alex Pichler says, “Most compound machines are found on the 52-week high list and very rarely are found on the 52-week low list.”

The key to successfully investing in growing businesses is to search for those businesses where the stock market has underestimated either how long a business can grow (durability) or how fast it can grow (rate of growth).  We have learned if we can find companies that are underestimated on both these measures, they tend to produce the best investment results.  On the other hand, we must also take care to identify where the market is overestimating these same measures.  We have learned that the stock market rewards faster growth more than durable growth, as when shoe company Crocs carried a high multiple for many years, later crashing when the faddish shoes stopped selling as well.

Second, we must be ever vigilant in understanding why the business is growing.  A key lesson from our investment in the for-profit education industry was that many schools manufactured their growth by using aggressive recruiting tactics and facilitating student loans instead of allowing natural demand to fill their classrooms.  This proved to be unsustainable growth.

Expanding Our Inventory of Ideas

During the year, another of our key priorities was to expand our inventory of ideas (our primary source for investment leads) so we can improve the odds of finding a great investment.  We believe that if we have more high quality businesses on our radar, we can make more powerful comparisons and finer distinctions among businesses.  For example, as we added businesses with high growth potential to the inventory of ideas this helped us decide to reduce positions in opportunistic stocks as we believed the growing businesses had less risk and more upside potential.

To expand this inventory of ideas, we have been conducting an in-depth search of U.S.-based company filings of publicly traded businesses in order to add new founder-led companies to our inventory.  As we qualify these founder led companies using our investment checklist we focus primarily on those businesses with growth potential.  We also examine the compensation structure, ownership, company culture indicators, and whether the business is solving legitimate customer problems.  As a result of this effort we have added over 300 new investment leads to our inventory of ideas.

[us_separator]This post has been excerpted from a letter to partners of Compound Money Fund, LP.

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