We want to share with you on how we develop a formal process to identify and research investment opportunities – Holon’s research approach that narrows our focus. This allows us to zero in on investment themes where we have strong knowledge, and have a strong outlook for growth. We present it here, in five better investing steps.
Step 1: Narrow your focus
One of the most important things to do when first constructing an investment portfolio is to focus on investment themes where you already have a base understanding.
According to a study released by the OECD in 2019, there were 41,000 publicly listed companies in the world with a total market capitalization of US$80 trillion. Obviously, an incredibly large field of companies in which to get lost, so building a set of investment filters that can help narrow your focus will ensure a higher probability of success in your long-term investment performance.
One of your first considerations should be in deciding which sectors or investment themes have the strongest market forces driving their long-term growth. This historically translates into higher valuations and share price performance, often referred to by professional investors as ‘swimming amongst the strongest currents in the river’. As we accelerate into the digital age over the next few decades, it’s likely that technology will remain among the fastest-growth opportunities for your portfolio. Other examples of better investing via long-term growth include healthcare (as Western populations grow older), education (benefiting from rising wealth in the developing world) and the environment (the switch to green energy and transport).
Sectors or investment themes that face a more uncertain future, such as fossil fuel energy production, or that face rising social opposition like pharmaceuticals or gambling, risk underperforming over the long-term as more investors divest their holdings based on environmental, social, and governance (ESG) considerations. Investors should avoid these sectors unless they have knowledge that gives them an advantage over most other investors.
Step 2: Stick to your strengths
Once you have decided on the sectors or investment themes you would like to initially target, an additional step worth considering is to break each of these into smaller segments so you can further narrow your focus.
For example, the technology sector includes an enormous range of investment opportunities, including software, e-commerce, semiconductors, and payments, as well as new emerging technologies like blockchain, artificial intelligence, IoT (internet-of-things) and autonomous transportation.
Each of these technology segments may offer high-growth opportunities, but require specific knowledge, learnt through either practical experience (working in the field) or undertaking extensive research, to correctly identify possible risks. This knowledge will also give you greater confidence during market or company-specific price declines because you will confidently understand each of your investments, reducing the likelihood of panic selling.
Holon’s Photon Fund, for instance, has invested across diverse opportunities within the technology sector that include electric vehicles, payments, and e-commerce. But to date, the Fund has excluded areas like semiconductors and biotechnology because we haven’t yet built the necessary level of expertise to fully understand the key drivers and risks within each of these areas.
Step 3: Identify the best companies in your target sectors
Once you have narrowed your investment field down to target sectors or investment themes, it’s time to start your research to identify companies that are best positioned to benefit from the long-term demand growth in the sector, or ‘the fastest companies in the fastest currents of the river’.
Better investing includes identifying the company with the largest market share, either globally or across a single geographic region, is a good place to start. If you read through several prior years of quarterly and annual reports, you should get a good understanding of the company’s business operations and its main drivers of revenue and profit growth. The company’s website will also provide a detailed overview, as well as any meaningful announcements.
It’s worthwhile paying particular attention to management discussions within each earnings report that provides an outlook on the company’s operations, as well as future plans. A jump in capital expenditure (and associated depreciation), for example, can lead to a slowdown in reported profit margins and could also impact its share price. Management discussions may provide insights into the timing of a recovery in profit margins and assist you with building out your financial model.
For each company you single out, have a look at some of the qualities that Holon looks for in a great business, for better investing:
– Regional and/or global market leadership
– Scalable business model leading to a global footprint
– Financial strength
– A highly innovative mindset
– Strong leadership with ‘skin in the game’ (an ownership stake in the company)
– Demonstrated ability to launch new business segments
– High free-cash-flow generation (either now or in the near future)
– A long-term business plan
– Driving the shift to the digital world (Web 3.0)
Step 4: Pinpoint opportunities, or threats
As part of their research, a professional investor also develops a solid understanding of any possible threats from competitors in the same sector, or new entrants. This research can sometimes uncover more attractive options than your initial target and can also help you to identify any new innovative technologies being developed by competitors that could quickly shift customers towards a new product (of a different company) at the expense of existing market leaders.
The surge in demand towards electric vehicles is a recent example. As seen in Figure 1, Tesla’s 11-fold increase in EV production has delivered investors a 21-fold share price increase over the past 5 years. General Motors on the other hand has seen a 37% fall in vehicle production from 10 million units to 6.3 million units since 2016. Its share price is up 72% over this period, with all this move occurring in 2021. Misreading the shift in innovation towards EVs almost certainly resulted in a hugely missed investment opportunity in Tesla.
Figure 1: GM vs Tesla electric vehicle production & share price
Step 5: Understand the geographical and political footprint
Globalization over the past few decades has seen industry leaders expand into dominant market positions across dozens of countries. Technology is the most obvious example, with social media platforms like Facebook (now Meta) reaching almost 3 billion customers, making it the dominant social network in 156 countries, while Amazon’s e-commerce platform is established in 13 countries and services an additional 100 countries. It is important investors understand a company’s exposure to each geographic region.
Laws and regulations covering each sector differ substantially across the world. Shifts in government policy often leads to confusion, closely followed by panic selling, when investors overreact to the news. This has been the major cause of share-price weakness in Chinese equities of late, after local regulators introduced new laws tacking anti-competitive behavior and data privacy.
Rising political differences, in particular conflict between the US and China, as well as China and Australia, can lead to sanctions that can have an enormous impact on a company’s operations. This played out across the Australian agriculture sector during 2021 when China imposed sanctions on local producers, including wine and grains. While the Australian government has tackled the issue through the World Trade Organization, local producers have lost substantial revenue and other global producers have stepped in and taken over their customer orders. Once again, understanding the risk of political sanctions on a company’s operations will help settle nerves when investors react to any negative news flow.
The next steps
For better investing, the steps we have outlined above provide a framework so investors can answer the most important questions to ask when analysing a company.
What does the target company do?
And does your research confirm that it offers an attractive risk/reward profile for your investment capital?
While not an exhaustive approach, if you follow a similar approach you should cover off on many of the essential topics Holon believes are required to begin to answer these vital questions.
Next month we will shift our focus towards how to build a basic financial model that will assist with quantifying the financial strength and current valuation of the target company. Happy investing.