Invesco: Seven habits of highly effective investments

1. Growth

Over the years we have found we are much more likely to find attractive investment opportunities in healthy, growing companies – regardless of whether they are “growth” or “value”. A company that grows is not about investment style, it’s a fundamental building block of almost all of our good investment ideas. There are several ways in which companies can grow: new markets, new customers, new products, value accretive M&A etc.

In our experience, businesses that aren’t growing, tend to be going backwards. Not all growth opportunities enhance shareholder value, therefore it is important to understand the track record of the company and the management team and their ability to deliver an economic return from such ventures. We look for companies that are sustainably growing shareholder value through the cycle and can deliver returns above the cost of capital.

2. Price

Price isn’t about value investing. In our experience it is often the lowest multiple (“cheapest”) companies that prove to be value traps. Paying the right price is about understanding what a company is worth: it’s intrinsic value. It is only by doing the fundamental analysis and gauging the intrinsic worth that you can make a judgement on what is the appropriate price to pay for the asset. We want to pay less than what we believe the company is worth and will wait for the market to provide this opportunity.

3. Margins and moats

Most Investors want to invest in high margin businesses; it often infers the company is unique in the product or service that it offers. Apple¹ would be a good example of this: a loyal customer base, who are embedded in their ecosystem, have no choice but to be loyal – giving Apple high margins. This ecosystem provides a wide investment moat. However, businesses that can sustain high margins while growing sales are rare and they tend to attract competition. Companies that have low margins can be attractive also, as long as they have a moat which is defendable. In fact, sometimes having low margins can be an effective competitive strategy and enable a company to take market share from less effectively run competitors.

Ryanair² is a great example of a low margin businesses, that has been successful; its moat is its lower cost base than competitors, this in turn drives volume growth which allows them to drive supplier costs down further. Customers ultimately win as they receive lower prices. The key is determining which companies can maintain their moats, allowing them to achieve future growth.

4. Owners and management

We want management to act like owners of a company; they should be aligned with us as investors; both in how they are remunerated and how they deploy capital. Some of our best investments have been in family and founder owned enterprises. These agents act as owners on our behalf and act in the best interests of the business for the long term, rather than trying to meet next quarters earnings.

In the absence of material share ownership (the gold standard in our view) management teams should have clear, simple and measurable financial targets that incentivise good capital discipline, with particular focus on cash generation and returns on capital. Companies need to clearly define hurdle rates of return for capital investment and acquisitions, ensuring that they are value accretive for shareholders.

5. Balance sheet and leverage

While leverage can provide increased returns, it also comes with added risk. Taking on balance sheet risk in economically cyclical companies is particularly high risk. Leverage should be used in a risk conscious way that is appropriate to the individual company and industry. Conversely, those companies with net cash, which they are able to deploy at attractive rates should be seen as desirable; while returning cash to shareholders is another lever to add value.

We’ve found that many of our founder owner businesses run with net cash, oftentimes indicative of their prudence and focus on cash generation. The combination of cash to deploy in the hands of aligned management team can provide both optionality and potentially greater downside protection.

6. Cash flow and dividends

Our preferred metric for valuing companies is free cash flow; it is less easily manipulated than earnings. Quite simply cash is the best measure of a company’s health; without being self-financing from a cash flow perspective, the business cannot be a going concern for any material period of time. Cash flow allows the company to pursue those opportunities which enhance shareholder value: investing at attractive rates, paying down debts, buying back shares or paying a dividend. We believe that investing in companies that can sustainably grow their dividends over time will not only provide an important contributor of return, but provides an important discipline for companies in managing their cash flow.

7. Different lenses

We believe that the fundamental analysis we do is exhaustive: we read a great deal of both recent and historic annual reports , listen to management earnings calls, speak to analysts and experts, as well as competitors and customers. We try to build a deep, holistic understanding of the business, the opportunities and risks that it faces. Ultimately, we seek to make a judgement on how the business will fare in the future, versus the price we are being asked to pay for it today.

However, as investors we are not all knowing; we all have our inadvertent biases. We therefore also evaluate companies through independent lenses, for instance EVA (understanding a firms economic rather than accounting profit) and QRR (assessing accounting and earnings quality). Our best investments tend to survive not only our scrutiny, but those of our independent partners as well. 

^¹ Not held in the Invesco Global Equity Income Strategy

^² Not held in the Invesco Global Equity Income Strategy