We have developed a number of proprietary screening tools that are used to identify mispriced opportunities. These tools are aligned with our investment philosophy and focus on the following key metrics:

• Return on equity
• Price to book value
• Dividend yields
• Normalised returns (e.g. normalised return on equity and normalised operating margins)
• Price-to-earnings (PE) ratios and normalised PE ratios
• Implied growth (e.g. implied growth in dividends, earnings and net asset value growth).

We look at long-term valuations and prefer to buy when the valuations are low/cheap relative to their own history. Our extensive research on mean-reverting factors, namely the above key metrics, provides conclusive evidence that mean-reverting factors do influence the direction of the JSE indices and that considerable outperformance can be generated by harnessing these phenomena.

Mean reversion is evident in factors related to the market price of stocks (probably caused by short-term investor overreaction), as well as in factors pertaining to business fundamentals and where the company is in its current business cycle. Although most factors generate outperformance for holding periods as short as twelve months, holding stocks for longer periods of up to five years increases the likelihood of achieving reversion-related gains from these strategies.

In our study, we tested eight different mean-reverting metrics. The results are as follows: Our analysis shows that the mean-reverting factors convincingly outperform the universe, on average by about 5% a year for longer holding periods. Note that returns generated by mean reversion in return on equity require longer holding periods to manifest. This is the only factor that contains no market information and would be expected to revert more slowly, following business as opposed to market cycles.

Once we have highlighted potential value opportunities, we overlay our fundamental research capability to identify stocks that give us the necessary conviction to make meaningful investment decisions. In this regard, we do our own proprietary research. Our focus is on understanding each company’s competitive advantage and translating this into an assessment of the company’s worth, based on its sustainable cash flows over time.

The more stocks you have in a portfolio, the greater the probability that the portfolio returns will look like the index. By owning fewer stocks you typically increase your odds of beating the index. Of course the opposite is also true if you get it wrong. We prefer to limit our exposure in any one company to 10% of the portfolio. By default, this means the minimum number of stocks in which we will be invested is 10 and we will only invest when we have a high level of conviction and the odds are in our favour.

An unavoidable consequence of this approach to investing is that the portfolio may be more volatile relative to a benchmark in the short-term than a benchmark cognisant fund. We construct portfolios based on potential long-term risk-adjusted returns (with a mindset of maximising long-term returns and minimising the risk of capital loss), not index weights, sector exposure or otherwise. In considering how much to own of each business, we take into account upside potential, conviction and liquidity. The first two factors have been well explored in areas outside finance by John Kelly, now known as the Kelly Criterion. We use the Capital Governance Model (CGM) as a guide to assisting us in allocating capital. The CGM uses a combination of the Kelly Criterion, mean variance and the Omega function to calculate the potential weight of a stock in our portfolio. We use this as a guide in determining the size of the investment identified in each opportunity. Key considerations of the CGM that dovetail with our view of investing are:

• The importance of wealth preservation
• The concept of only making big investments where the odds are in your favour and the risk-reward relationship is attractive

We have implemented the following guidelines for constructing the SIM Unconstrained Equity Portfolio:

• Minimum holding of 1.5%
• Maximum holding of 10% (this is not a prescribed rule, but one that is generally applied)

We normally start with a position of 1% (depending on liquidity) and build this up in small increments moving in a certain direction until something happens (most likely either the stock reaches fair value or we see better value elsewhere, we reach a liquidity cap or in the unlikely event the fundamentals change). We seldom make dramatic changes in either direction. Ultimately, however, the percentage of capital allocated to a stock is decided by the portfolio managers. Models are only used as a guide.

The total number of stocks we will own will depend on the number of opportunities. In the extreme case of the whole market being equally cheap, then the best risk-adjusted strategy would be to own more stocks. If there are fewer mispriced opportunities, then a far more concentrated portfolio would maximise risk-adjusted returns.

We always ask ourselves the following three questions before investing in a company:

1. Is this idea significantly better than the existing ideas we have in the portfolio?
2. Do we understand the risks being taken?
3. Would we be happy to have a large portion of our personal wealth fluctuate in relation to the prospects of this business?

Investing is as much about avoiding the disasters as it is about picking the winners.

We do not see risk the same way as traditional modern portfolio theory would. Risk does not reside in relative price changes and cannot be summarised into a single number. The Oxford English dictionary defines risk as the possibility of harm or injury. In the world of investing, this translates into either:

• A permanent loss of capital and/or
• Your savings not keeping up with inflation (at worst) over time

Our focus is on the risk inherent in the underlying businesses in which we invest. We look at the risk of new competitors impacting on the returns that a company has generated in the past. We also carefully consider the balance sheet risk (amount of leverage a company can comfortably repay) and finally the quality and track record of the management team we are partnering.

We will consider any unintended consequences that may arise as a result of our bottom-up stock picking approach. This is more to gain an understanding of exposure to currency, portfolio cyclicality, companies with high degree of leverage and other factors that may be regarded relevant at the time.

Finally we are able to track different portfolio metrics over time such as upside to fair value, P/BV, ROE and implied variables (growth in earnings or dividends). This gives us a sense of the “valuation risk” of our client’s portfolios.