Buying businesses, not stocks: The key to an all-star portfolio

Ally Selby

Livewire Markets

Unlike those who champion the merits of a diversified portfolio, Claremont Global's head of international equities, Bob Desmond, has an entirely different philosophy. 

Investing, according to this portfolio manager, is much like picking players for sporting teams - and before you roll your eyes at the cliché, hear the man out. 

"If you've got Michael Jordan in your team and Scottie Pippen, how many others do you need?" Desmond explains.  

"Let's not dilute the core here and add a whole lot of fringe bench players." 

When it comes down to it, really good ideas - just like really good basketball players - are rare. So, if you have "a good idea you should really concentrate your capital in it," Desmond says. 

For this reason, he encourages investors to own a concentrated portfolio of just 10-15 stocks; featuring only the best players - or ideas - rather than a cluster of around 50 companies (or more) to reduce capital risk. 

It's little nuggets of wisdom like this - as well as many others - that the Zimbabwean-born fund manager shares with Livewire Market's Patrick Poke in the latest episode of The Rules of Investing podcast. 

In this wire, I'll summarise some of Desmond's key messages from his chat with Patrick, including the benefits of portfolio concentration, and why he prefers businesses like Microsoft and Alphabet over Tesla. 

The case for concentration

Desmond is a firm believer in investing in "businesses" rather than "markets", concentrating his portfolio around his best 10-15 ideas to avoid index-like returns. 

"There are only a few great businesses in the world, ones which I think can sustain their competitive advantage for a decade," he explains. 

"There are even fewer that are run by people we trust and that we think are rational. And then there are even fewer that are priced at the right price for us to make a good return on our investment." 

To find these great businesses as you swim through the mania that is markets, Desmond's advice is to think like a business person; maneuvering your capital to bolster and strengthen the "best division" of your business - or in this case - the market. 

"We would never invest in a business and say to them: 'Let's take the money away from the golden goose and just spread it all around and try to buy more and more businesses that are actually less good than the original business," he says. 

"So if you extend that logic (to investing) it makes sense to me to take your capital and your clients' capital and invest it in those businesses that are your best ideas."

Another reason for adopting the 10-15 stock portfolio - and this may come as a shocker - is that there are only 24 hours in the day. And you need (we assume) to sleep at some point. 

These limited waking hours mean it is hard to keep on top of a 100 or 200 stock portfolio, as well as interest rates, economic policy, political tension, commodity movements - the list goes on. 

"It's very, very hard to do that well," Desmond says. 

"And so, I've always thought of myself, not really as someone who invests in markets, but as someone who invests in businesses." 

Respect your elders

Just because something has been around for the best part of the last century - doesn't mean it can no longer grow. 

"The average business in our portfolio is over 73 years old, but the underlying earnings in the portfolio are growing in the mid-teens at the moment," Desmond says. 

"Just because a business is old, doesn't mean it can't grow at a reasonable rate." 

Instead of searching for new businesses with promising products or services, look for businesses with a sustainable competitive advantage, he says. 

"If they've got that, then it's very predictable what those businesses can earn in the future," Desmond explains. 

"They don't have to be slow-growing, fast-growing, Growth, or Value - but we want their competitive moat to stay intact. So in five years time, which we run our valuations off, we have a really good idea of what that business looks like and what it's going to be earning." 

One such business is London Stock Exchange-listed Diageo (LSE:DGE); the world's second-largest distiller, which produces the likes of Johnnie Walker, Smirnoff, Captain Morgan, Baileys, Tanqueray and Guinness, to name a few. 

"We are pretty comfortable that Diageo is going to be around, they have spirits brands that are 200 years old, people are going to keep drinking spirits ... emerging market consumers are getting richer, they are going to trade up to decent imported spirits," Desmond says. 

"So it doesn't have to be a fast grower, but we have a fairly good idea of where that business will be and what they will be earning in five years." 

Another "older" business than Desmond is excited about is Aon (NYSE:AON), an insurance broking firm with various financial risk-mitigation products.

"That is an industry which over time tends to grow at 4-5% - GDP basically - not really that exciting," he explains. 

"People have to insure their buildings, they have to insure (against) cyber-risk, they have to insure against director malfeasance; as a CEO or a CFO, you don't wake up one morning and go: 'Well, maybe this year we won't insure the building and hope it doesn't burn down.' Its 80% reoccurring revenue, 90% client retention."

This business prints an enormous amount of cash, Desmond says, while management buy-back nearly 4-5% of stock every year. In the meantime, expenses run at 2%, and revenues run at 4%. 

"You do the maths on that and you easily have a low double-digit grower," Desmond says. 

"In a business that is pretty old and boring, but is growing at 10-12%. And you are paying 20x earnings for that now, so 10% less than the market multiple ... it ticks all our boxes." 

How to identify good management

Quoting Warren Buffett, Desmond says good management is rational, honest and resists the institutional imperative. 

"A lot of people who end up running businesses are obviously very good, they are very intelligent, they are very competitive and they are also not 'shrinking violets', so they really trust their own abilities," Desmond explains. 

"Obviously they would, why wouldn't they? That's why they have ended up being the CEO of the business."

The danger with this type of over-confident business leader is that they can overestimate their abilities, often ending in tears. It's overconfidence like this that has seen companies like Woolworths try their hand at DIY, while an overconfident GE expanded from its core industrial businesses to credit cards, financial businesses, property and media. 

"So I think that's the first thing, being humble enough to admit that you have inherited a really good business. And then just focusing all your resources on making that an even better business," he says. 

Other identifying factors of good management - staff who hang around (e.g. a CEO who has worked there for 30 years), leaders who make mistakes and admit it, and companies that walk away from a bidding situation that gets too expensive; they "don't do massive acquisitions funded by huge amounts of debt". 

"You are looking for management that is humble enough to admit mistakes, but arrogant enough - or confident enough - to not follow the crowd," Desmond says. 

Tantalising talent within big tech 

Big tech has been nothing short of tantalising over the past 12 months. The NASDAQ has lifted more than 45% in the year alone - and that's after the 6.5% pullback that we have seen over the past fortnight. 

Tesla (NASDAQ:TSLA), Elon Musks' much-loved electric vehicle manufacturer, has led the charge. Its share price is up around 354% over the last 12 months alone and it's now worth more than the next ten largest car manufacturers - combined. 

"They produce half a million cars a year and BMW produces two and a half million cars per year, so five times what Tesla produces. But the market cap difference is US$50 billion for BMW and US$850 billion," Desmond says. 

"So do the maths on that, per car, Tesla is worth 85 times more than BMW." 

For the naysayers who may argue that Tesla is a software company, Desmond has another nugget of wisdom. 

"It doesn't look in the numbers like its a software company, its got an 18% gross margin. We own software companies that have 80% gross margins and the switching costs are huge and there is a network effect," he explains. 

"If I sold my Tesla, well its no problem, I can just get an Audi or a BMW, Mercedez, Porsche - take your pick, there are lots of them - nothing bad is going to happen to me. So I look at that and think that's crazy, but it just keeps going up." 

Desmond has a ~9% portfolio exposure to Alphabet, which he believes is growing at a rate of 20% per annum over the next five years.

"It's not so much Value or Growth, its predictability and competitive advantage which we are looking for - and whether we can access that at a reasonable price," Desmond says. 

In spite of these levels of growth, Alphabet (NASDAQ:GOOGL) is an entirely different story to that seen in Tesla, he says. 

"We own Alphabet, which has a $1.3 trillion market cap and this year will probably make $50-odd billion," Desmond says. 

"If you do some quick adjustments, they have $125 billion net cash, so strip that out. They have some loss-making businesses, which we can't capitalise at a negative value - so let's just say they are worth nothing, so strip those out. So core Alphabet - core Google - you are paying 26x earnings for." 

The average business currently is priced at 22x earnings, Desmond explains, so Google is only "four points more expensive" than the average business. 

"I don't think that is unreasonable for a business that has 90% share, that pretty much dominates search advertising globally," he says. 

Similarly, Facebook (NASDAQ:FB), (which Desmond doesn't own) is no Tesla, he says. 

"Strip out the cash on Facebook and you are paying 22x earnings; you are paying the market multiple," Desmond says. 

"Now that's a business that at its last result grew 33% in revenue, I think their EPS was up 56%, it has 2.5 billion users around the world.

"That doesn't seem crazy to me, that's quite reasonable." 

A grower for the ages

When asked which one stock Desmond would invest in - if markets were to close for five years - he pointed to Microsoft (NASDAQ:MSFT). 

"It is so ubiquitous in our lives. And they have four great businesses: Windows, Office, Server and now Cloud Azure. It's a $1.7 trillion market cap business, it's still growing its top line at over 10% per annum," he says. 

"I can't imagine a world where businesses could operate without those tools ... so you have an amazing lock on customers."

It's this cloud business, in particular, that has Desmond excited. 

"It's a scale game, and there is really only going to be three players in the game, which is Amazon, Google and Microsoft," he says.

"Tech spending as a percentage of GDP is probably going to double over the next decade - so they are really, really well placed to capture that." 

Also playing to Microsoft's benefit: a "fortress balance sheet, net cash of $60 billion, we can easily see a path for them growing at 15% per annum over five years," Desmond says. 

An oldie - but a goodie. 

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Ally Selby
Deputy Managing Editor
Livewire Markets

Ally Selby is the deputy managing editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian...

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