Before going into details about picking the dark horse, here is a story of Bo Le, a man in ancient China renowned for his ability in selecting the finest horses.
So one day, Bo Le was tasked by the King of Chu with the mission of finding a stayer that could run 1,000 li a day. Back in his times, one li was equivalent to around 0.41km. That means the horse would need to be able to cover over 410km in a day.
And of course, horses like that were not easy to come by, if they even existed at all.
Unsurprisingly, Bo Le met failed candidates after failed candidates before he ran into a fatigued and malnourished-looking horse that was awkwardly pulling a waggon loaded with salt up against a steep hill.
But something special about that horse caught his keen eye, and after further examination, he decided that this was the horse that would be capable of the feat if given proper grooming. He was right—the horse was indeed one with amazing speed and endurance, and it later made great contributions on the battlefield.
The moral of the story: Dark horses and “hidden champions” are hard to spot, and they are often underestimated and underappreciated. But Mohammed Ali-Reda, Managing Director at Darkhorse Capital Ltd, suggested during his Value Investing Summit presentation that investors would be better at spotting dark horses if they adopted a different perspective.
A company’s value is not wholly defined by market capitalization and liquidity
When it comes to investing, the MSCI, the S&P 500, and the Straits Times Index (in the local context) are benchmarks that investors tend to track.
But the limitation of doing so, says Ali-Reda, is that such indices only consist of the most prominent companies. To him, indices serve more as financial checkboxes that present to investors companies with sufficiently large market cap and good liquidity, but it cannot fully represent a company’s value.
“Personally speaking, the filters that I apply to assess companies are a bit different. For instance, I value management skill and experience over market cap and liquidity,” he added.
A profiting company might not always profit the investor in the long run
Another key point to take note, suggested Ali-Reda, is the company’s capital allocation. To him, essentially, what the company does with its capital tells you about how they think of you as a shareholder, as well as where they see value.
He noted that some businesses would use their capital to create more value or invest on your behalf, while others might use it to gather more assets for themselves without thinking about the return on their capital.
“I call that growing their empire,” he said. “And I don’t want to be invested in companies that are solely concerned about growing their empires.”
Instead, take note of companies that keep their words and hit their targets
Changes in stock prices supposedly reflect the changing demand for the stock or changing expectations of the company’s profitability.
In Ali-Reda’s words, when we invest in a company, we are actually “buying” its future earnings, and thus we want to know its pattern of behaviour and see if the company has actually achieved what it had previously promised or aimed for.
He cited the example of Philippine Seven Corp, the local franchise holder of 7-Eleven convenience stores in the Philippines, which had consistently hit its store expansion target in 2009, 2010 and 2013.
Note that Philippine Seven Corp aims to populate the country with 10,000 stores in eight years’ time. Considering that it had 1,980 stores in 2016, there is still a lot of room for growth.
Laser Focus versus Broad Diversification
While investors might be familiar with the advice “don’t put all your eggs in one basket”, Ali-Reda suggested an alternative: “Or you can put them in one basket and watch them very carefully.”
This is similar to the concept of evaluating companies within one’s circle of competence, a concept termed and popularised by Warren Buffett.
In fact, Ali-Reda takes it to another level for himself—before he invests in a stock, he strives to be among the top five percent of the people who know about it.
After all, it takes a Bo Le and not just an animal enthusiast to find a dark horse.
8I Education will be conducting a 1-day complimentary Value Growth Workshop on 11th, 12th or 25th Feb 2017 where you’ll get to learn the applications and possibilities of Value Investing.