Arlas’ investment strategy is alive and evolving. I do not think that there is an all-weather ultimate investment strategy and I am not looking for it. I think that it is essential to have some principles (rooted on the value investing tradition) to estimate the quality and attractiveness of different businesses and, consequently, to decide if at a given price, they are worth having on our portfolio.
I look for good businesses. I can often recognize good businesses by focusing on pricing power and market sizing. Pricing power is often driven by the competitive dynamics of an industry. Businesses with substantial competitive advantages usually enjoy better pricing power. I assess not only the size of the competitive advantage, but also its trend (stable, increasing or decreasing size of competitive advantage).
Arlas Capital operates with a concentrated portfolio of stocks that generally fulfil two conditions. First, they have to be good businesses: they are those that have pricing power and generate substantial free cash flow. Second, they have to be good investment opportunities: they can be acquired with a significant margin of safety.
Occasionally, we also invest in fair quality businesses with exceptional valuations: price dislocations may at times present extraordinary investment opportunities. Very exceptionally, we also invest in asset plays and special situations.
In any case, each portfolio company should have a capable and trustworthy management and an adequate financial structure. We like to invest in companies with a conservative capital structure, which is defined as low levels of leverage and a healthy cash flow cycle.
What is a good business?
Good businesses benefit from clear, sustainable competitive advantages. In practice, this means that I look for companies that have pricing power. These competitive advantages generally come from a combination of network effects, intellectual property, control of distribution channels, natural or legal monopolies, economies of scale or scope.
What is a good investment opportunity?
A good investment opportunity is a business that is bought with a healthy margin of safety. As a rule of thumb, I usually ask for a 20-30% margin of safety for good businesses. For asset plays and special situations, that minimum margin of safety goes up to over 50%. I assess the margin of safety from a financial perspective, meaning that we carry out a fundamental bottom-up analysis to assess the upside of a stock as well as the margin of safety protecting the invested capital. We also carry out an assessment of the company from a qualitative perspective. We spend a significant amount of significant time understanding business fundamentals by meeting/ calling company executives, industry participants, and/ or other industry experts.
Overall, I consider that my work is successful when, with an (always) incomplete amount of information I can have a clear idea of how well the company will do for the next 10 years. I have the luxury of thinking long term thanks to a stable capital base. In my experience, short term results are over-appreciated and long-term evolution is overlooked. The quarter on quarter evolution of companies is closely followed by some fund managers, but sometimes the long-term evolution is not as well understood and followed. I succeed when I can understand this long-term evolution and keep a cool head as long as necessary for the business to evolve to unleash its potential.