Capturing Alpha

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Quality businesses are capable of generating excess return — Excess return is frequently lost or destroyed prior to reaching shareholders  — Capturing alpha is essential to generating successful investment returns.

Capturing Alpha

Our investment philosophy is designed to invest in businesses capable of generating excess returns, and equally important, capturing these returns for our clients. We first filter our universe using a strict quality criteria, then narrow this “buy list” by requiring a discounted valuation, capable management, and strong balance sheet. These three aspects of our investment philosophy allow us to capture alpha, or said differently, prevent the transfer of our returns to other stakeholders.

Discounted Valuation

As the recent market drawdown has demonstrated, it is possible to identify high quality businesses generating excess returns and still fail to generate investment returns. By ignoring the valuation of investments, even for the highest quality businesses, shareholders transfer their future returns to other, more savvy sellers. For every shareholder that overpays and experiences a loss on their investment, an equal and opposite seller has benefitted from the sale, regardless of the attributes of the underlying business.

We attempt to be a beneficiary of this return transfer by maintaining a strict valuation discipline. Valuation risk is a tail risk – market drawdowns are infrequent but generally drastic. By always being conscious of valuation we seek to ensure we are not transferring future returns to the seller before our investment has even started.

Capable Management

Any excess returns generated by a business must go through management’s hands before being captured by shareholders. This makes management teams our partners and an indispensable asset (or liability!) to our clients’ returns. While every dollar spent matters, risky mergers and acquisitions and excessive compensation are two surefire ways for management to siphon returns from investors. We avoid situations where shareholder returns are diverted away for management’s gain.

Strong Balance Sheets

Businesses with weak capital structures run the risk of transferring shareholder returns to creditors. Businesses are increasingly run with “optimal” capital structures, which enhance shareholder returns in the short-term but simultaneously increase the risk of substantial loss in the long-term. A decade of attractive shareholder returns can be immediately erased if the company must hand the keys to their lenders.

While outright bankruptcies have become increasingly rare, weak balance sheets chip away at shareholder returns in other ways. In early 2020 we watched many businesses raise highly dilutive capital to ensure they would survive the Covid crisis. In hindsight, creditors struck amazing deals and equity holders were impaired.

We stress test the balance sheets of our investments, generally analyzing performance in prior recessions to gain confidence that our returns will be protected even in extreme scenarios. In addition, we recognize the real option that a strong balance sheet creates – the best capitalized businesses went on the offensive during the Covid crisis,  buying back their shares at attractive prices.

The Logic Behind the Philosophy

Our philosophy is designed to both identify excess return opportunities and ensure we capture those returns. Valuation, capable management, and strong balance sheets are all risk mitigants, attempting to protect us from capital loss due to value being transferred out of our investments. In this way our philosophy has the added benefit of serving to protect capital in drawdowns, a  valuable attribute for our portfolios. We’ll happily focus on risk over returns if the result is alpha generation, and capture, for our clients.

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IMPORTANT NOTES & DISCLOSURES

The information, analysis, and opinions presented herein are for discussion and educational purposes only. This presentation is not an offer to sell securities of any investment fund or a solicitation of offers  to buy any such securities. Nothing contained herein should be construed as investment advice nor should it be relied on in any manner as legal or tax advice, or as an offer to sell or a solicitation of an offer to buy investment advisory services. Securities of the funds managed by Reference Equity are not offered to investors. All investments involve risk and, unless otherwise stated, are not guaranteed.

The information in this presentation was prepared by Reference ISC GP LLC and/or Reference GSC GP LLC (“Reference”) and is believed by Reference to be reliable and has been obtained from public sources believe to be reliable. This document may contain certain forward-looking statements, opinions and projections that are based on assumptions and judgements of Reference in respect to, among other things, future economic, competitive and market conditions and future business decision, all of which are difficult or impossible to predict accurately and may of which are beyond the control of Reference. Reference makes  no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this presentation constitute the current judgement of Reference and are subject to change without notice. Any projections, forecasts, and estimates contained in this presentation are necessarily speculative in nature and are based upon certain assumptions. It can be expected that some or all of such assumptions will not materialize or will vary significantly from actual results. Accordingly, any projects are only estimates and actual results will differ and may vary substantially from the projections or estimates shown. This presentation  is not intended as a recommendation to purchase or sell any commodity or security. Reference has no obligation to update, modify or amend this presentation or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

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