Investing is the act of allocating capital such that said capital grows at rates above the cost of obtaining it. A professional investor, i.e. one who charges others to manage their money, must
generate returns not only above the cost of capital, but above the average of all other investors in order to earn the privilege of being in this business.
It is incredibly hard to achieve above average returns, as vastly explored in academic literature.When questioned by asset allocators how they do it, most investors, whether it is an event driven arbitrageur, a leveraged credit investor, a venture capitalist, or a multi-strategy hedge fund will claim that they are trying to exploit some kind of “market inefficiency”. The problem with this narrative is that these so-called market inefficiencies, which for the most part refer to short-term price dislocations or scarcity of capital, tend to be ephemerous.
Over the years, when asked this same question by current or prospective investors, we always struggled with the idea that market inefficiencies as described above would be the source of
our above average returns. Anyone who claims to be investing in a low-turnover portfolio with a long-term orientation should have a hard time explaining that their returns will be driven
predominantly by short term dislocations in price.
We decided to try and answer this question in a more rigorous way, starting not from a top-down view of market behavior, but from a bottom-up view of the businesses we invest in. What
exactly is the source of our investment opportunities? How can we frame this set of opportunities in a more systematic way? And how does this framework enable us to build a concentrated portfolio of outstanding businesses that can compound their equity value for generations?
Our conclusion is that we are also trying to utilize a system failure. However, one that is far more enduring, albeit much rarer, than those caused by the manic-depressive nature of markets.
First, we need to set the stage. While this is not a particularly popular assertion these days, we truly believe that capitalism is an incredible system that has created significant improvements
to societies that have embraced it.
The driving force behind capitalism is an individual’s desire to prosper which in turn fosters innovation, growth, and most importantly competition. The necessary conditions are the protection of property rights, the rule of law, and the prevalence of some degree of trust in people and institutions.
It works beautifully almost all the time. Most businesses, driven by the animal spirits of their founders and the incentives given to the agents that manage them, will choose to invest at rates of return that are barely above their cost of capital, with many not able to reach even that threshold and disappearing along the way. This process in turn leads to continuously improving products and services at increasingly lower costs to customers, contributing to wealth creation and improved standards of living across the world. Yes, there are a lot of problems in the world that could be blamed on capitalism. The middle class in developed markets is feeling squeezed, consumerism is rampant, and there are unequivocal pressures on the environment. But ask an individual who grew up in East Germany fifty years ago if his kids have a better life than they did, and the answer is obvious. Similarly, well-being statistics such as infant mortality, hunger rates, and life expectancy have improved at a higher pace in the last 150 years than at any point in recorded history.
However, capitalism´s relentless march to equalize returns and costs of capital, which in turn squeezes profit margins, will in rare occasions fail. The reasons are varied and many times serendipitous. This system failure will lead to the emergence of companies that can insulate their businesses and earn significant excess profits for extended periods of time.
Entrepreneurs and executives who find themselves in these very rare situations must choose how they will use the immense power bestowed on them by these circumstances. Those imbued with the right values and with a true long-term oriented mindset will seek to strike a balance between the maximization of profits and treating their customers, employees, and other stakeholders fairly. Whether their incentive to do that are based on moral views or on the desire to fend off competitors, who will inevitably come for their margins if they over-extend them, is an interesting but secondary discussion. In our experience, it is usually a combination of both factors that contribute to their behaviour.
Unfortunately, the vast majority of people in that privileged situation choose a much less virtuous path, focusing too much on the short-term maximization of profits at the expense of the ecosystem around them and of the long-term prosperity of their businesses, which will be attacked either by other competitors or the State. We see this behaviour as particularly prevalent in companies where there has been a nearly complete separation between ownership and executive leadership. This is a natural consequence of the incentive structures created to compensate management teams and by the poor oversight provided by corporate boards that are, most of the time, composed of people who do not have a true vested interest in the long-term success of the companies they were chosen to govern.
Our time as investors is spent searching for that tiny subset of companies in the proverbial haystack of the market that, on one hand, have been able to escape the gravitational pull imposed on returns by the forces of capitalism but who, on the other hand, are managed by people who have the incentives and perspective to think about generational value creation and who are driven by values to which we aspire ourselves.
Our investment opportunity is that discontinuity of capitalism, captured by the right people. Today we are shareholders of 19 companies that we believe belong to this very small subset. We
continue to test this assertion and to look for other similar opportunities, well aware that there are very few companies in the world that fit the bill.
Thank you as always for your attention and trust.
Regards,
Zeno Equity Partners
London, 18th April 2024
This communication is intended for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial products or transactions, nor an official confirmation of any transaction. Any comments made herein do not necessarily represent the views or opinions of Zeno and may be subject to change without notice. The summary description and
any other materials provided to you are intended only for information purposes and convenient reference and are not intended to be complete. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by any of Zeno, its partners or employees and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions. This information is not intended to provide and should not be relied upon for accounting, legal or tax advice or investment recommendations. You should consult your tax, legal, accounting, financial or other advisors about the issues discussed herein.
The distribution of this document may be restricted in certain jurisdictions. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation, and it is the responsibility of any person or persons in possession of this document to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction.
