Our Family of Funds: Some Common Principles
At Montanaro we are a family and so all our funds and portfolios have in them the same DNA. Our Global Select Fund may look different to our European Small Cap Fund or our Better World Fund, but like siblings in the same family, you can tell they’re related. We can only hope our clients, like proud parents, wouldn’t be able to pick a favourite!
The following are some guiding principles that inform the way we do things, across our family of funds.
1. Be a philosopher, not a strategist.
Those watching Ajax’s epic 2019 Champions League semi-final loss to Spurs may recall Jose Mourinho’s post-match quip that “the philosophers lost to the strategists”. Spurs’ street-smart ability to adapt usurped the stubborn philosophers who refused to compromise their style.
We think fund management is the opposite. Unlike a single football match, we never declare victory: there is no binary outcome in our world. We simply strive to make more right decisions than poor decisions over a limitless time horizon within a philosophy which we think will maximise the impact of those right decisions.
That philosophy is our distinct flavour of Quality Growth. We never deviate. Our profession is full of tacticians and strategists. Some modern fund managers have one philosophy, which is simply to make money, however they can. It is rare to find an investment house that applies a disciplined philosophy across its range. We are proud to say we do. Our in-house Quality Checklist (the way we define what makes a ‘Quality’ business) ensures that every business we invest in scores above its peers in metrics like growth, profitability, balance sheet strength, returns on capital, barriers to entry, competitive positioning, and product differentiation, amongst other things.
Whatever happens to the ebbing and flowing cycles of the market, we never compromise on our definition of Quality, and we never make exceptions to buy optically cheap but low-Quality companies (think of banks or oil companies), just because we think their share prices might have a good quarter.
The reason – aside from the fact that we think our approach makes more money in the long term – ultimately comes down to the fact that our clients are our partners, and for them to know what they are invested in, is sacrosanct. With Montanaro, the philosophy is crystal clear, so you know what you’re getting.
2. Hard work creates success.
Effort is a seemingly simple idea, but the world of fund management is not always acquainted with it. Having spoken about the philosopher and the strategist, we should mention the third type of manager: the closet index-hugger.
This is an approach of portfolio construction that seeks to emulate the benchmark in order to avoid meaningful underperformance. Instead of spending every hour of the working day trying to find the best companies to invest in, this fund manager spends their time looking at the constitution of the benchmark. This fund manager never takes their own risk. Which is not to say the closet tracker is free of risk; it simply takes on the benchmark’s risk – which is itself deceptively risky.
If you ask us as Quality Growth investors, we believe the risk of owning many of the low Quality structurally declining businesses in the benchmark is an unacceptable risk. It all comes down to perception, but in our view charging active management fees for this passive style of portfolio construction is at best lazy and at worst deceptive.
We feel strongly about this. Montanaro funds without exception have single digit or zero overlap with their peer funds and their index benchmarks. We find our own stocks. And it all comes down to effort. It’s not easy. Small Cap is under-researched. So, at every opportunity, we invest internal resources, time and effort. From hiring analysts, to speaking to expert networks. We speak with every management team of the companies we invest in, and we kick the tyres on the road to visit them.
We have the largest team of research analysts in our sector, and in 2020 we hosted over 400 company meetings. It’s not easy, and it’s resource intensive. But it pays off, and that’s what our clients trust us to do.
3. Give your ideas the time and space to pay off.
After putting in the effort to find high Quality gems, it’s important not to nip that hard work in the bud. Good ideas need time to pay off, and they need space within a portfolio to pay off.
“You only have to do a few things right in your life to make a lot of money, as long as you don’t do too many things wrong”. We certainly agree with Warren Buffet here.
The fund manager may be tempted to be too clever. Desperate to add value beyond stock selection, they will be tempted to trade the market aggressively. But in our view, excellent businesses should be given the time to yield fruit. After you have found a brilliant business to invest in, each subsequent decision introduces an opportunity for error. A new risk. The medieval philosophical principle behind Occam’s Razor says the same thing. That’s why at Montanaro we don’t trade quarters, or market movements. We don’t believe we are that clever, but we believe our companies really are. So we give them time, with a 10 year + investment horizon.
Space is different to time, but equally important. The active manager who emulates the index and runs a 75 or 100 stock portfolio does not give their ideas the space to pay off.
In our view diversification guards against human error, tail risks, and market timing. But too much diversification is the enemy of long-term returns, because it fights against the fact, established by Professor Hendrik Bessembinder, that the majority of stock market returns over time come from a minority of really exceptional companies. Winners keep winning, and most others either lose or simply survive.
So what is the point of investing in an exceptional company, just to bury it amongst 85 other holdings, as a 1% position in a portfolio? It could double, and it will have barely moved the needle.
We run high conviction portfolios of 30-60 stocks. This means that our ideas have the space to pay off, as well as the time.
4. Know what it means to invest.
Becoming an excellent investor is certainly a noble aspiration. But we believe a good place to start is to know what investing means.
We think the semantic distinction between ‘growth investors’ and ‘value investors’ is misleading and betrays a misunderstanding of investing. ‘Growth investing’ is a tautology. An investor who invests for capital growth and in growing assets should not really be a ‘growth’ investor; they should simply be an ‘investor’. ‘Investing’ and ‘growth’ are synonymous. The way the market prices shares – even by the most ‘value’ based standard, is by sizing up the weight of future cash flows; so to find a company which is growing its cash flows must surely be the point.
Growth, let’s not forget, is the bedrock of capitalism. The central equation of macroeconomics is the production function Y = A*KL, which writes GDP as a function of the capital base, the country’s working population, and a productivity factor, A. GDP growth is a function of capital growth and labour growth, whilst ‘A’ is largely a function of technology. Tracing global GDP over thousands of years shows its tight correlation to technological breakthroughs and subsequent capital growth. Participating in the growth engine that is capitalism, must surely be the raison d’être of investing.
By contrast, buying an asset for no fundamental reason other than that you believe it is mispriced on arbitrary metrics, in order to sell it on at a more efficient price, is not ‘investing’. It is either re-selling or it is trading.
Meanwhile, buying an asset that you believe is mispriced, and worth less than the value of its future cash flows is not ‘value’ investing. This is proper growth investing. This is exactly what we do. We are Quality Growth investors who believe that if we can get an edge on understanding the likely growth profile of a company, we can buy it at a price that is below fair value, and make money in the long term because the growth of its capital base and its future earnings will lead to a higher share price via very clear pricing mechanisms, which we spend a lot of time on.
To say that Growth investors like us do not pay attention to valuation would be like saying a Formula 1 driver cares more about top speed than handling. It is not a particularly meaningful comment.
Investing for growth and for the long term is a tautology that should not require defending or qualification. What’s left is simply to find the best companies. Easier said than done, but we do our best, and we are very proud of the ones we have!