Steve Lipper: Mark, tell us how do you organize research?

Mark Rayner: Well, you know, we’re pretty much of the view on the strategy that we don’t actually want to be a value investor or a growth investor. Both are very interesting, of course. Something with a low current multiple is interesting. Something with good growth is interesting. We think the most interesting of all, though, is high return on investor capital. That’s the thing that links the two. So that’s our focus. That’s our definition of quality, companies with high and consistent returns on investor capital. We call it QARP, Quality at a Reasonable Price, and we’re big believers in the power of compounding. So our starting point is that we’re process driven stock pickers looking for companies with high returns on invested capital. So we can screen very efficiently for companies with high returns on invested capital.

And we also screen for companies with conservative or strong balance sheets. In our view, that has a number of advantages, one of which is that we can de-risk to a degree the company by having a strong balance sheet, but also good companies should have quality balance sheets. If they don’t, maybe they’re not as good as we think they are or their capital-allocation policy is wrong. So we screen for companies with high returns on investor capital and strong balance sheets. And then we say, “Look, there are certain characteristics that we want to find in our companies.” For example, they sell to a customer’s operating budget rather than their Cap X budget. They provide very important or mission-critical products or services. And one of the things also that we like to do is stick very much in our circle of competence. We need to understand the customer benefit. We need to be able to describe that to someone else, I think that’s always a good test. And then, finally, we use something called Enterprise Quality Scoring. That scores companies out of 100 on a series of metrics.

SL: Maybe spend a little more time on EQS and the parameters there, because it is the link point between those things that are initially a part of the screening to those things that are then qualified and eligible to go into the portfolio.

MR: Enterprise Quality Scoring or EQS has nothing to do with valuation, which is an interesting point. We’re not screening for value. We’re looking at quality at this stage. What is our conviction that this is a quality company? So we’ve developed a framework. This was over a decade ago. We’ve developed a framework which enables the PM or the analyst to think about his companies in a specific way, and also, over time, to return to those companies to reevaluate his initial opinion. Let me walk you through it in a little more detail. So we score companies out of 100, and they’ve got to score at least 70 to get into our database, and without being in the database, they’re not eligible for inclusion at some stage in this strategy.

Now, the scoring actually spells out the acronym SCORE, S-C-O-R-E. And very quickly on those letters, the S stands for Sector. We like companies that are operating in niche markets which are structurally growing where the makeup of the market is fragmented from most sides, from supply base, customer base, no big competitors, et cetera. The C is Competitive Position. So given that market backdrop, what does the company do to create pricing power? And we like to understand and evaluate that. The O is how good is the company at converting that pricing power into operating cash flows? The O stands for Operation. So how good is it at managing its P&L or how good is it at managing its balance sheet? The R is simply Records. We look at the company’s record of producing return on investor capital and its balance sheet and give them a score for that. And the E is a little bit of a catchall. We call it Extras. So we’re looking at things like ESG. We’re looking at our rating of management, the KPIs that the company is driven by. So we put those altogether, score the company out of 100. And, as I mentioned, to go in the database, make you eligible to go in the fund you need to score at least 70.

SL: There’s just a few people on the team that are doing this. How do a few people cover all the opportunities?

MR: It’s a great question, and to be honest, Steve, it’s probably the question we get more than any other. And I get it, 4,000 companies, small team. How do you cover it? The answer is we can’t. We don’t try, and most importantly, we don’t need to. At the end of the day, we’re trying to build a portfolio, which is relatively concentrated. We want to make few mistakes and compound away with high-quality companies. Now, how do we do that?

First, you start from screening. We screen these 4,000 companies for returns on investor capital, for balance sheets and also for liquidity. Then we look for certain attributes, and we can do a lot of this actually still at a desktop basis. And then when we go and meet the management at these companies, we then score them on the Enterprise Quality Scoring System, the EQS System. And that enables us to build a database, which we’ve been working on for over 10 years, of something like 200 companies, which are eligible for inclusion in the fund.

So we don’t cover the world. We don’t try to. But we think with the process, and our discipline of only looking for companies with certain characteristics, that we can sift through the world very efficiently.

SL: What role do you feel pattern recognition plays in the process?

MR: That’s very interesting. We’ve found, over the years, that certain industries and certain countries are much more target-rich than others. For example, Spain is not going to produce very many targets for us, where Switzerland and Sweden will. So, logically, let’s spend more time in screening Switzerland and Sweden. If you look on an industry basis, retailers, or certainly banks, we’re going to find very few, if any, targets there. But we know, for example, from our previous work that specialty chemicals, professional services, application software companies are going to be very target rich in the industry space. So we spend more time on screening in those areas.

Important Disclosure Information