There are many mathematical ways to describe a company, including its profitability, its growth rate, and its dividend yield. You can then rank each company’s attractiveness using these metrics, and combine them in many different ways. For Octagon this is just the start of the process. We use mathematical descriptors to identify companies that might be mispriced and then we dig deeper to try and understand why that might be so.

Management: How good for how long?

Running a business is not easy. Understanding how the company makes money, how cash flow has trended over time and how it compares to similar companies (sometimes, but not always in New Zealand) is an important way to analyse the future prospects of a business. Management teams which have been realistic about their prospects – because they have a strong understanding of how their business makes money and the environment they operate in – are a key factor for investment success, in our opinion.

Overly sensitive valuations need not apply

We believe that valuing businesses is impossible without forming a view of the future. The assumptions around profitability, the level of investment required to grow and the competitive backdrop need to be reasonable. Niels Bohr, a Nobel laureate physicist, famously quipped “Predicting is very difficult, especially if it’s about the future.” So once we have a set of assumptions, we run scenarios around our view of the most likely operating environment. If a small move in one assumption changes the valuation by a lot, it signals greater valuation risk.

Having worked out how we think a business operates and its financial metrics, there is a fourth step. Test and learn. How is the company doing against our prior expectations? Are we constantly being surprised by the level of profitability, the level of investment required, the way competitors are behaving? These surprises could be positive or negative relative to our expectations, but if there are a lot of them, it implies we, and probably management, haven’t yet truly worked out the way the business sustainably makes money. 

Experience supports judgement calls

After all of that, we apply judgement based on years of following a company, the industry it operates in and the market backdrop. We consider the overall risk of the portfolio in this step. We want to retain diversification, to ensure we are not too exposed to stocks that all rely on the same factor and to ensure the expected volatility of the portfolio is reasonable.

Building conviction

After all of that, we apply judgement based on years of following a company, the industry it operates in and the market backdrop. We consider the overall risk of the portfolio in this step. We want to retain diversification, to ensure we are not too exposed to stocks that all rely on the same factor and to ensure the expected volatility of the portfolio is reasonable.