Investing during a time of accelerating rates of business change and rapid innovation across all industries is a very tricky endeavor fraught with complex challenges. It adds another dimension of analysis to the research and selection process. Gauging how business leaders will be able to compete amidst this ongoing business disruption is a serious challenge facing investment managers today.
Even if a management team has currently built a strong competitive advantage in their industry, how can they protect and grow their position against new game-changing challengers that could come from… anywhere? Rita Gunther McGrath, Columbia Business School professor, global strategy expert, and author of “The End of Competitive Advantage – How to Keep Your Strategy Moving as Fast as Your Business” has warned that traditional approaches to business strategy no longer apply to our cross-industry business environment of hyper change and disruption.
To dive deeper into this investment challenge, I was glad to be introduced to Aaron Chan, Founder & Managing Partner of Recurve Capital – a concentrated hedge equity strategy that has been grappling with these issues and developed a unique investment process for determining quality companies that can navigate this Age of Innovation and Disruption.
Hortz: How did you start your path into money management and then develop and refine your investment process? What are the key lessons you have learned and how are you applying them?
Chan: I was fortunate to join a hedge fund, Criterion Capital Management, right after I graduated from Stanford in 2004. I was the first analyst hired at Criterion and trained under three partners who invested globally in technology, media, telecom, and business services companies. It was a wonderful experience to see a lot of investment opportunities across different sectors, geographies, and investment styles, such as China internet growth, emerging market telecoms, US turnarounds, IPOs, and more. It was invaluable to gather experience in so many different situations early in my career so I could sort through what made the most sense to me and, perhaps as important, what was out of my comfort zone.
As I gained experience, I developed my own personal investment philosophy: to start analyzing businesses first before assessing the stock and its valuation, to seek investments for which returns would be generated by growth in free cash flow per share, and to concentrate into a select group of high conviction, high-quality investments. I learned early on that I was pretty bad at calling short-term trends for industries or companies, but thankfully I was better at assessing longer-term dynamics. Over time, I was able to refine and implement my investment strategy, including spending 6.5 years deploying my investment process at MIG Capital, until I founded Recurve Capital in 2021.
Hortz: Many investment managers state that they only buy “quality” companies or businesses. How do you define what is a quality business and how do you further classify those quality companies into “builder” companies that you would invest in?
Chan: Many investors focused on quality tend to assess them based on backward-looking metrics. There are lots of ways to assess quality quantitatively with financial ratios – return on invested capital, operating margins, free cash flow generation, return on equity, etc. There are more levels to analyzing quality, such as looking at a company’s pricing power, its market share, its growth rate, etc. The beauty of the market is that if you ask 10 investors what they mean by “quality,” you will get 10 different answers, but they probably gravitate to a few important concepts, like high returns on capital, significant free cash flow generation, and healthy growth.
We use our “Builder Company” framework to identify and assess companies that we think could be candidates for our portfolio. These are companies that are proven market leaders which are continuing to build structural advantages that should support long-term gains in market share and, consequently, earnings power. Our process is built around assessing forward-looking quality of these companies over a medium- to long-term horizon.
Our framework is designed to identify companies that have five key characteristics: (1) they are proven market leaders, (2) they have strongly validated customer relationships and unit economics, (3) they operate in healthy end markets, (4) their competitive advantages and unit economics improve with more scale, and (5) they are led by owner-oriented management teams. These qualities are necessary to pique our interest, but not sufficient for us to invest. Of course, there are other factors like valuation, the risk/return potential, our conviction in the range of outcomes, and others that are significant factors as we look at the medium- and long-term investment horizon.
Most of our Builder Companies invest in significant vertical integration and/or platform advantages which serve as their structural advantages compared to smaller competitors who do not have the same degree of scale and owners’ economics. We want our companies to serve happy customers who come back repeatedly because they receive significant value across multiple dimensions from our Builders, especially superior service and value. We look for companies and management teams that act as disruptors across different end markets, the speed of which varies considerably by company.
Hortz: You mentioned that you like to focus on companies that have healthy end markets. Can you explain for us what you look for to determine a healthy end market?
Chan: The health of an end market is one of the most important areas of assessment for us. We spend a lot of time studying current competitive dynamics and extrapolating how they may evolve over time. We see many investors itching to jump into hot growth trends (like generative AI) without giving enough consideration to long-term competitive dynamics which can sometimes turn a great growth story into a bad outcome for investors.
I saw this a lot when investing in emerging market telecom companies early in my career – they would enjoy fantastic performance as mobile penetration rates grew from <10% to 30-40%, but then competitive pressures hurt returns across the sector after the “easy” growth was absorbed into the market. I have fallen into the trap of buying cheap “value” stocks only to lose money because too much competition entered the industry, hurting pricing and profitability. These experiences, and many more, pushed me into caring a lot about how an industry should develop over the next ten years. If I do not like an industry in year 10, I would not like it in years one through nine either.
In general, we have a preference ranking for end market structures that is fairly easy to follow and understand:
-
Unregulated monopolies
-
Rational oligopolies
-
Fragmented competitive markets
-
Regulated monopolies
-
Concentrated competitive markets
While there are many amazing companies in the “Unregulated Monopolies” bucket, we tend to find most of our investments in “Rational Oligopolies” and “Fragmented Competitive” end markets because we find that they tend have more attractive risk/return profiles for various reasons. Rational oligopolies tend to exist in more mature end markets, but there can be some great opportunities for long-term value creation among them.
We get excited when we find leading companies in “Fragmented Competitive” markets that have a long runway to gain share from a large field of smaller competitors. In general, the less a competitor can feel the direct impact from our companies in their markets, the easier it will be for our companies to win over time. A Builder Company in a fragmented industry can generate meaningful and growing advantages through economies of scale which should create a nice flywheel effect in its end market. Managed the right way, over the long term, that company and industry could move up a notch or two in our ranking – to a rational oligopoly or an unregulated monopoly.
Additionally, we seek companies that are adding significantly more value to their ecosystems than they extract. We want to own companies whose customers love to use their products and services, and we prefer them to ones which extract economic rents from customers that are given begrudgingly due to poor alternatives. For example, for most of their existence, cable companies have been the poster children for the dynamic we are trying to avoid – poor customer service, high prices that only go up, and low net promoter scores from customers. They were able to thrive for so long because they were local monopolies, but their poor service levels invited new competition (streaming video and fixed wireless broadband) which has hurt them significantly in the long run. If they had provided outstanding and growing value to their customers without trying to monetize every minor upgrade in services, perhaps the video distribution market would have evolved differently.
Hortz: With our business environment driven by an accelerating rate of change and being impacted by disruptive technologies, how do you research the ongoing market dynamics around your portfolio companies and determine how they may evolve in the future? How do you gauge a management teams ability to build durable competitive advantage in this rapidly changing business environment?
Chan: This is a challenging time to assess longer-term competitive dynamics in many technology-enabled industries, especially because of the recent advances in generative AI. Lisa Su, CEO of AMD, said in September: “I’m not a believer in moats when the market is moving as fast as this.” We agree with her sentiments and are happy to sit on the sidelines around similar fast-moving trends if we find it too difficult to assess the long-term competitive dynamics for a company or industry. Because the quality hurdle is high for our concentrated, long-term investment strategy, we are okay missing out on some big winners because we also will avoid some really big losers.
We focus our research efforts in areas of the market that have demand and competitive dynamics that are easier to predict. For example, we know that Americans will take vacations to see different parts of the world. We know that the global population will consume more bandwidth over the internet. We know that companies and customers will continue to seek faster/better/cheaper products and services. As long as our companies can operate and build growing competitive advantages within some basic frameworks of known future needs, we feel comfortable making investment decisions on longer-term time horizons. It is an iterative process powered by curiosity and our goal of understanding if our target companies and their surrounding ecosystems are supportive for significant equity appreciation over time.
Our research process is focused on three primary areas: (1) understanding our companies’ structural advantages versus other competitors, (2) creating a detailed understanding of our companies’ unit economics and how those change with time and scale, and (3) assessing their long-term growth potential. The individual steps in our research process likely look similar to other fundamental investors, but our focus, concentrated portfolio, and long holding periods allow us to spend much more time on each company we study to ensure we have a robust understanding of how our companies satisfy all the characteristics we seek in Builder Companies - of being disruptors versus being disrupted.
Hortz: What do see as the benefits of concentrating your portfolio?
Chan: Concentration is one of the few structural ways to create an index-beating strategy, but we think it must be approached with the right mindset. It would be irresponsible to manage a concentrated portfolio without adhering to a disciplined strategy, without maintaining a high threshold for quality, and without a steady and patient approach to portfolio management.
Our concentration is an output from two foundational goals: (1) we want to maximize the returns from our best ideas, and (2) we must conduct deep, thorough fundamental research on every investment to ensure we can behave optimally as new information comes our way. We eliminate most new ideas quickly due to a variety of factors. Most businesses we look at fail to make it through our Builder Company framework, and many companies that meet our quality standards are less attractive due to their valuations and their risk/return profiles. Because we prefer to be fully invested, new ideas must be meaningfully more attractive than our existing positions to enter our portfolio.
Most of our companies trade at single-digit multiples of free cash flow on a medium-term horizon and we expect them to grow their underlying free cash flow per share at high rates well into the future, which we expect to be the primary driver of future returns. These are not easy to find and after running ideas through our selective process, we want to invest enough to make a meaningful impact to performance when we find a handful of companies that have the right characteristics at attractive valuations.
Maximizing exposure to the best opportunities we can find makes rational sense, but it is a strategy that many find difficult to follow or uncomfortable because of the mental anguish around drawdowns and the psychological safety net that diversification provides. We also would be drawn to a more diverse portfolio if we did not study our companies and their industries tirelessly and if we did not have high thresholds for quality and return potential. For our strategy and process, concentration is a natural output that makes the most sense.
Hortz: In selecting your concentrated group of quality businesses, do you apply any diversification or other portfolio construction measures in building your investment portfolio? Do “Builders” tend to cluster in certain areas?
Chan: This is a great question! We tend to search for ideas among companies which sell products and services that are relatively easy to understand and whose economic inputs and outputs are not directly linked to macro variables, like oil & gas and financials. In terms of building our portfolio, we like to find Builder Companies that share the common characteristics we discussed earlier but generate demand from diverse end markets and industries. While this evolves over time, we currently own companies that sell products and services in markets like fiber connectivity, auto retail, e-commerce, luxury goods, building materials, and leisure/vacation. On the surface they do not obviously fit together, but we see significant commonality among them as Builder Companies.
Because we tend to own the clear market leaders, if we already have an investment in one end market, the hurdle is higher for us to own another company in that same end market. However, there are certain industries that are so large and fragmented that our companies may technically operate within the same sectors, but rarely interfere with each other.
Our companies also tend to share a common trait of having fixed/low variable cost structures which generate high operating leverage, margin expansion, and earnings growth that exceeds revenue growth over time. This is a characteristic we actively seek in our investments. Most often, these fixed cost structures are the product of significant fixed investment which also tend to be the source of their growing competitive advantages. However, operating leverage can swing performance in both directions – it magnifies both the good and the bad times.
Hortz: Any thoughts you can share on how advisors and asset allocators can position your hedge fund investment style in their portfolio construction process and client portfolios?
Chan: I strongly believe there is a place for concentrated, performance-oriented strategies in every portfolio, especially in an investment world that now has over half its assets in passive products which often outperform diverse, active strategies net of fees. Concentrated strategies complement passive index products to materially enhance returns for patient, long-term investors that can allow their capital to grow over many years or decades.
That said, the allocation to these types of strategies is highly dependent on an investor’s comfort with volatility. Concentrated portfolios tend to have mark-to-market performance similar to individual stocks, and investors in concentrated strategies should be aware that volatility is an output of the strategy, not a controlled input. Every investor would love to have owned Amazon, Google, and/or Apple over the last 20 years inclusive of all the volatility, but most investors in funds or partnerships are not accustomed to that level of volatility. A different mindset should be considered for concentrated investment products.
While I believe high-returning, concentrated strategies have a place in every investor’s portfolio, I also believe investors should only allocate to strategies that (a) they can understand and make sense to them conceptually; (b) have a cogent, consistent, and repeatable process; and (c) have performance and volatility dynamics that they can tolerate.