Our investment goal is preserving and compounding our clients’ capital over the long term. It leads us to:
We believe the best way to achieve our investment goal is investing in high-quality businesses at a price we believe offers a significant discount to intrinsic value. We define a high-quality business as one that maintains above-average profitability throughout the economic cycle and where the business is expected to grow over the years. We often find dominant players in niche markets fit this profile. By owning these businesses for the long-term, we frequently experience both elimination of the valuation discount and intrinsic value growth as the size of the business and profits increase. We prefer to own these companies as long as we maintain confidence they are not grossly over-priced and the intrinsic value will continue to compound.
The Opportunity in Japanese Small Caps
Quality businesses usually trade at premium valuations in most developed equity markets. However, we believe the Japanese small cap market is one of the few markets which uniquely offers investors attractive valuations for such businesses.
We believe this is mainly because:
- Growing number of small public companies
Japan has over 3500 public companies and, unlike other developed markets, it is still growing every year. The majority of them would be defined as micro-cap or small cap companies by global standards, and we believe they are too small for most global institutional investors.
- Lack of quality information
Although disclosure has been improving, it is still true that gathering information on Japanese companies, especially smaller companies, is a challenge for most global investors. This is because:
- Most of small companies provide public filings only in Japanese
- Most small companies are not covered by analysts of major sell-side firms
- Most of small companies in Japan don’t have a dedicated department, or personnel for investor relations. Even if they do, he or she will usually only provide information in Japanese
- Low capital efficiency
Many quality small-cap companies have large net-cash balance sheets as result of free cash flow generation over the years. Despite many of them having quite high returns on invested capital, their overall return on equity tends to be low. Many global investors consider low return on equity as a sign of a low-quality business or poor capital allocation and avoid them. It is true that many Japanese management teams have strong preference for conservative balance sheets, but we believe striking a balance between improving capital efficiency and maintaining a strong balance sheet is acceptable for many management teams in Japan.
We believe there are no short cuts to identify high quality under-valued opportunities in the Japanese small cap market. To calculate intrinsic value, we need to get comfortable with the sustainability of margins and growth prospects of the business. Our fundamental research before committing capital includes review of public filings, and meetings with the company, customers, suppliers, competitors, and other investors, etc. (Maybe cut the part about Other Investors? I would say we can actually add “What we don’t do is rely on the input of other investors or sales side analysts to reach a conclusion.”) Even after our initial investment, we continue our research process to try to learn more about the business. Since available information on Japanese small cap companies is limited, we really need to turn stones one by one. But, we believe the potential reward of this time consuming, bottom-up, fundamental research is large in our universe.
Partnership with Management Team of Portfolio Companies
As a long-term owner of quality businesses, we usually develop constructive relationships with management teams of portfolio companies. We offer them our knowledge of global financial markets and network of business leaders and investors. Since we only invest with well-run businesses, we rarely advise them on how they should run the business. Instead, we focus on advocating the importance and benefit of proper and logical capital allocation because we believe the importance of compounding intrinsic value per share over the long term is not well understood in Japan.
We believe there is strong virtuous cycle of long-term investing and active dialogue with management teams. It usually leads us to a better estimate of intrinsic value as we deepen our understanding of the business. Also, by having a stable, long-term shareholder with good understanding of businesses, management teams can focus on long-term business strategy to grow intrinsic value per share.
We use investment results and not asset growth as our benchmark for our success. We believe in the importance of being an investment led firm as opposed to a sales and marketing driven one. A sales and marketing-led company spends more time and money gathering assets than it does investing the money it’s already gathered. An investment-led company focuses the majority of its efforts on compounding clients’ capital. That is what we have in our mind when think about how we build and manage our own business.
This belief leads us to following discipline:
- Independence: We believe the successful value investing requires independent thought and willingness to move away from the herd. Although value investing has worked over time, it has underperformed (quite badly) time-to-time. Therefore, we believe ownership of an asset management firm is crucial to being consistent with its investment philosophy. In our case, a majority of our firm is owned by employees and an entity controlled by employees’ family.
- One Strategy: We would like to focus on one investment strategy, which we believe is the best to achieve our investment goals. We are not going to launch second- or third-best idea products just to grow our asset base.
- Assets Size: We have seen countless examples of investment firms that failed because they got too big. We continue to carefully assess the appropriate size of our firm’s assets to capture the best investment opportunities.
Alignment of Interest with Investors
Our personal, professional, and financial success is tied to long-term performance of companies in our portfolio. We focus on investing in companies of which the management teams are compensated based on the long-term success of their business. This alignment of interest is fundamental to the way VARECS invests.
We welcome investors who share our value discipline and long-term approach to the investments. We believe having a like-minded investor base is one of most important factors for the success of our investors, our portfolio companies, and ourselves. We promise to treat our investors as true partners and provide timely and direct communication on both our failures and successes.
We would like to build a corporate culture based on honesty, humility, and humor. These values guide how we interact with our clients, our companies, our colleagues, and other business partners.
Honesty means not only admitting our failures and successes to clients and ourselves, but also being intellectually honest. We can’t truly understand everything about a business after a month of research. After owning a company for over 10 years, we still learn something every time we meet the management team. Value investing is not complicated. It is a rather simple concept; buy high-quality companies at cheap prices. But practicing it is not easy. As value investors, we have to be humble because the future is uncertain, our understanding of our companies is limited, and inherently difficult nature of value investing (maybe change this since we just said it is simple – “understanding the intrinsic value of a company is inherently difficult”). Lastly, each of our investment professionals considers themselves an analyst. We all enjoy learning new things every day and discussing potential investment ideas. Even in his 80’s, Mr. Buffett says he tap dances to work every morning. We may never fully understand how he feels every morning, but we try to make our firm a great home for people who are passionate about value investing and fundamental research.