The Power Of Exclusion

“He who chases two rabbits catches neither” – Confucius

In Peter Seilern’s recent newsletter, he ran through the tumultuous events of last month involving the collapse of Silicon Valley Bank, the rescue of Credit Suisse and what this all means for interest rates and markets. In it he reminds clients why we never invest in banks. My newsletter expands on the broader topic of exclusions, and why these are critical to the long-term protection of capital.

Missing out on opportunities is a fact of life and a key feature of being a global investor. Whilst for some the ability to invest across all sectors of the equity market gives them range, for many this range can lead to superficial analysis, which can ultimately drive poor long-term returns.

For over 30 years, the Seilern investment philosophy has sought to minimise the risk of incurring a permanent loss of capital through its highly exclusionary process. This comes from our core beliefs that one should not try to be all things to all people, and that superior returns over the long run are as much driven by what you do not invest in as what you do invest in.

Seilern’s Ten Golden Rules form the bedrock of how we assess whether a company fits our strict Quality Growth criteria. However, they also do something equally as important – they give us a clearly defined view of why a company is not Quality Growth. Having a set of unambiguous investment principles cannot be underestimated as a powerful tool which helps investors navigate through turbulent times such as these. Most critically, they help to significantly reduce the risk of style drift, which is an asset allocator’s worst nightmare.

The Art Of Saying No

An unconstrained global equity investor has the ability to put capital to work across a universe of c57,000 listed companies. Perhaps ChatGPT will one day be able to conduct fundamental analysis on this many companies instantaneously, but until then the humble human must narrow its attention to increase the odds of success. One must simply begin to exclude, but how?

Seilern’s exclusionary process is set up in a number of stages which are a direct consequence of the Ten Golden Rules. We exclude companies with a market capitalisation of less than USD 3 billion as we run large-cap, daily trading funds. We exclude companies listed in non-OECD markets given our belief in the rule of law and the governance standards which underpin mature market listings. We exclude companies with poor financial characteristics, including things like low growth, low margins, low returns on invested capital, and too much debt. We exclude companies without at least a three-year track record since IPO, as well as excluding companies in sectors which are not Quality Growth.

We will expand on this last exclusion stage shortly, however, for the curiously inclined, the result of the above is that the potential investible universe of c57,000 companies reduces drastically to only c500 companies. This implies that we immediately exclude over 99 per cent of the listed global equity market prior to beginning our bottom-up research.

Some may argue that this removes far too many opportunities from the table. However, our experience has taught us that if a pure Quality Growth company is to be found, it will likely reside in this concentrated list. In the end, Quality Growth investing is about reducing risk and increasing your probability of returns, rather than betting on all horses in the race.

From this list of c500 companies, the investment team then embarks on fundamental analysis to exclude at least a further 90 per cent of these companies. This results in the formation of what we call the Seilern Universe – a list of the 50-70 purest Quality Growth companies from around the world which have been unanimously approved by the entire investment team.

What Is And Isn’t Quality Growth?

Whilst there can sometimes be quite a lot of subjectivity across the investing world as to what actually constitutes Quality Growth, its definition has been very clear to us for a long time. And whilst certain sectors of the economy may change over long periods of time, thus either entering or exiting our own Quality Growth universe, the principles underlying our sector exclusions have remained constant.

Below we outline some of these sectors and some of the reasons why they do not pass our Ten Golden Rules. This list and these reasons are by no means exhaustive.

Banking. As everyone knows, a bank makes money by borrowing short from deposits and lending long by making loans, hoping to make as large a spread as possible. It is therefore completely bound to the cyclical gyrations of the yield curve, which means it has very little pricing power. Not only this, but traditional banks derive their future cashflows from the fair value of their loan book on the balance sheet. These assets are notoriously complicated to assess, which significantly reduces the transparency of their accounts. And when financial stresses arise, this opaqueness, alongside a highly leveraged business model, can lead to incredibly fast bankruptcies.

Energy, Mining and Resources. One may argue that demand for basic resources and energy are long-term structural growth drivers, however, much like banks, companies in these industries are at the mercy of global supply and demand imbalances. As there is little product differentiation (after all, they are called commodities for a reason!), pricing is out of their control. This results in poor returns on capital over the long term as capital expenditures are often deployed most aggressively at the top of the cycle.

Utilities. The provision of public services plays a critical role in the global economy, however, the regulated nature of utility companies results in sub-optimal capital allocation given they often have returns on capital capped at limits which are, once again, dictated by the external debt funding environment. This usually results in capital intensive business models and highly leveraged balance sheets, which are backed by the trust that regulatory changes will not permanently alter their ability to generate excess free cashflows.

Telecommunications. In a nutshell, Telco businesses simply do not have ample long-term secular growth drivers which are independent of the economic cycle. They are companies operating in exceptionally competitive markets with very little pricing power and highly leveraged balance sheets. Not to mention they are usually highly regulated given the critical nature of telecommunication infrastructure to the economy, which means that capital is unable to be allocated in an efficient way.

Real Estate. By their very nature, real estate companies and real estate investment trusts (REITs) operate in a highly cyclical end industry, characterised by the typical booms and busts of fluctuating property prices, leasing occupancy rates and high indebtedness. REITs also must legally pay out at least 90 per cent of their taxable profits to shareholders in the form of dividends, which in our eyes results in an inability to deploy excess capital effectively to help fund future growth prospects.

Heavy Industrials. This is a catch-all category which includes a wide array of sectors such as transportation and construction. The key feature common to all heavy industrial businesses is the enormous ongoing capital needed to fund future growth. Whilst this capital can certainly create high barriers to entry for competitors, it is also usually deployed at inopportune times given it is highly correlated to the broader economic cycle. One only needs to look at the airline industry to see how consistently capital has been destroyed over the long run.

Conclusion

The critical takeaways from the above list are clear. Quality Growth is focused on investing in industries with secular growth rather than cyclical growth, which also retain the highest quality characteristics designed to protect investors from incurring a permanent loss of capital. We do not chop and change this definition to suit short-term market environments in an attempt to time cycles. Rather, our strict sector exclusions help reduce the risk of style drift, and keep our attention focused on finding companies with sustainable earnings growth through cycles, not during cycles.

Whilst we have undoubtedly missed many short-term investment opportunities in the past, and will likely continue to do so in the future, we strongly believe that the best way to grow and protect our client’s wealth over the long term is to be as highly selective and disciplined as possible. Indeed, this has driven excellent and stable long-term returns for clients, with our longest running share class having achieved an annualised return of +7.9 per cent¹ since inception in 1996, compared to the MSCI World Index return of +5.9 per cent².

And whilst our exclusionary process allows us to understand how our funds ought to perform during different market environments, there is little we can do in those years when cyclical sectors do well. An investor in 2021 would certainly have enjoyed not being exposed to banks and energy companies, only to have experienced the opposite emotions in 2022. Fast forward to 2023, and it appears as though another 180 degree turn has occurred before our very eyes.

Despite the fact that these twists and turns can have big impacts on short-term performance, our aim has always been to create the purest Quality Growth product possible, ensuring consistency so that clients know exactly what they are buying. Having a clearly defined philosophy, which can be implemented in a repeatable, process-driven manner, is what ultimately makes or breaks the true Quality Growth investor.

Marco Lo Blanco,

31st March, 2023

¹Seilern World Growth CHF Retail Hedged Share Class, net of fees, 15/01/1996 – 31/03/2023 (27.2 years)

²MSCI World Index Total Return in CHF, 15/01/1996 – 31/03/2023 (27.2 years)

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