Exclusive Interview with Aamer Khan of Qualivian Investment Partners

Qualivian Investment Partners is nearly a 3 year old long-term oriented investment firm with a very solid investment philosophy. The firm generated a cumulative return of 47.4% during its first 2.5 years and outperformed the S&P 500 Total Return Index by 25 percentage points. You are probably surprised to hear about an investment firm that managed to beat the market by double digits.

Most hedge funds and mutual funds fail to beat the market because of their large fees or hedges. Qualivian Investment Partners is long only and charged only 2.4 points in fees over the last 2.5 years (its gross return was 49.8% and net return was 47.4%). A typical hedge fund that charges 2 and 20 would have taken away 5 percentage points in management fees and another 10 percentage points in performance fees, leaving investors with only a 35% net return.

Two months ago we have obtained a copy of Qualivian’s 2020 Q2 investor letter and shared its views on its top and bottom performers. Its top two performers were PayPal (NASDAQ:PYPL) and Amazon (NASDAQ:AMZN), and its bottom three performers were TJX Companies (TJX), Brookfield Asset Management (NYSE:BAM), and Adobe Inc. (NASDAQ:ADBE). You can read their views on these stocks by clicking the link above. We reached out to Aamer Khan to understand Qualivian’s investment philosophy and find out their top 3 highest conviction ideas. Sure, Amazon.com and PayPal are some of the best performing stocks this year, but are they among Qualivian’s top 3 ideas today?

Aamer Khan of Qualivian Investment Partners

Here is the first part of our interview with Aamer Khan:

Insider Monkey: Can you tell us about yourself?

I have a bachelor’s degree in mathematics from Harvard College and a master’s degree in applied mathematics from Oxford University. I then worked in banking for 4 years, before getting my MBA from the Wharton Business School. Immediately after my MBA, I spent several years in management consulting, mostly at the MAC Group/Gemini Consulting, where I gained insight on how businesses work from the inside, assisting them in strategy formulation and problem solving. However, during that time, I spent most of my spare time reading about, and engaging in, investing. I gradually realized that investing was my true calling. I then worked for the Principal Financial Group for three and half years as an equity analyst and got my CFA. I spent the next 16 years at Eaton Vance Management in Boston with the bulk of my time spent as an equity analyst and a portfolio manager on five equity funds. I co-founded Qualivian Investment Partners in 2017.

Insider Monkey: When and how did you decide to start an investment fund?

In 2017 I linked up with a former colleague from my consulting days, Cyril Malak, who had worked for Putnam Investments. We both had similar thoughts about the dysfunction of the current asset management model and felt a better approach existed. Our Archimedean point was the proposition that wealth creation in equities is ultimately the result of the power of compounding of capital. Therefore, the correct investment model should be based on maximizing the power of compounding and minimizing those frictions which reduce it. We cleared our minds of the current “conventional wisdom” about asset management, took a blank sheet of paper, and started from first principles. Out came a model that addressed the defects we had identified.

Insider Monkey: What is wrong with active management today?

In a Nutshell: Asset management started out as a profession, evolved into a business, and, in an increasing number of cases, has mutated into a racket. Initially, fund companies’ and portfolio managers’ primary role was to create wealth for their investors, and, in the process, they would create some wealth for themselves. In a strange twist, this is now reversed: asset management companies’ and portfolio managers’ primary role now is to use investor funds to create wealth for themselves and, in the process, they create some residual wealth for fund investors. It is a bizarro world. This is partly due to increasing institutionalization of asset management by large firms, which has led to growing misalignment between the interests of the fund investor, the portfolio manager, and the asset management company.

Asset Management Companies: Large investment firms have become asset gathering companies, with a primary focus on growing the asset base and, secondarily, creating competitive investment returns. Their core competence is marketing, not investment management. They convince many investors to invest in funds with average or poor returns and high expenses, even when many better alternatives are available. Surely that is good marketing!  They incubate many funds, kill the poorly performing ones, and then advertise the best performers. The performance is stated on a time-weighted basis, which is not the actual return experienced by most fund investors. The dollar-weighted basis is better correlated with actual aggregate investor returns. Active fund investors get fleeced twice. First their funds underperform versus the lower cost passive index funds. Then fund investors underperform the funds they have invested in by over 200 basis points, because they are persuaded to get in when the fund is doing well and fear causes them to jump out when it is doing poorly. Mutual fund boards have a fiduciary duty to put the interests of the fund investors first, not the interests of the firm advising the fund. Given that there is an epidemic of funds with above market fees and below market performance, are they really doing their job?

Portfolio Management: From a fiduciary viewpoint, portfolio managers should be optimizing risk/reward in the portfolios they manage. This is not what they do. Instead, they optimize their own career risk.  This leads them to (1) prefer stable returns over higher, but less stable returns, and (2) avoid short-term underperformance which makes them look bad and could impact their year-end bonus and careers. These tendencies amongst many portfolio managers leads to suboptimal risk aversion: they take the right amount of risk for their careers but not the correct amount for their clients’ portfolios. For example, fund managers would rather buy a stock with an 8% expected return and 5% standard deviation than a stock with 15% expected return but 10% standard deviation. These errors of omission are far more costly than errors of commission.

Disadvantages of Large Institutions:

– Short term focus: The greatest advantage an investor has is a long-term focus, given that large swaths of the market are focused on the short term. Publicly traded asset managers, because they are judged by quarterly results, want to look good in the short term so they tend not to think long term. The same holds true for privately held asset managers who fall into a similar trap.

– The larger firms tend to have multiple levels of hierarchy, which leads to undue complexity, excessive information loss, bureaucratic politics, and unnecessary resource expenditure to manage internal boundaries.

– Hierarchy also leads to a deference and conformity to those in positions of power and attenuates independent investment thought and action. The investing frameworks of senior management were formed early in their careers when financial markets were very different. They are less likely to reassess and reformat their frameworks as financial conditions change, especially with the current structural shifts and disruptive transformations accruing from the digital revolution. They rely on fully amortized intellectual capital and are not likely to be challenged by more junior employees.

– Adverse selection occurs: the best analysts become portfolio managers, when competence as an analyst does not necessarily imply competence as a portfolio manager. The best portfolio managers become head of investment groups and spend much of their time on marketing and administrative tasks and less on investing.

The Current Portfolio Management Model and How to Improve It:

Current Practice 1: Diversify broadly across the entire universe of stocks that meet the investment mandate.

How to improve it 1: Realize that the vast majority of value in the market over the long term is created  by very few (less than 4% of the total) stocks which are characterized by structural and competitive advantages, high returns on capital, and excellent capital allocation. The research effort should be focused on these stocks.

Current Practice 2: An average portfolio has more than 60 names and high turnover, so over 100 names come in and out annually, many making cameo appearances. This causes cognitive overload for the portfolio managers, leading to a poor understanding of, and conviction in, many of their holdings. Stocks get “rented” rather than owned.

How to improve it 2: Concentrate the portfolio to a limited number of the highest conviction names so the portfolio managers have familiarity with each name.

Current Practice 3: Trade extensively on incremental information. Look and act “busy.”

How to improve it 3: Realize that almost all incremental information is noise. Ignore it and hold the quality compounders. Activity is not progress, often generating frictions that detract from performance.

Current Practice 4: Analysts present candidates to portfolio managers. Portfolio managers pick and choose.

How to improve it 4: Portfolio manager does his/her own work leading to conviction. Conviction cannot be outsourced to analysts.

There are lots of things broken in the field of investment management today.  Happily, at Qualivian we are free of the many distractions and perverse incentives suffered by the massive institutional asset gatherers. We enjoy the freedom to approach the fascinating challenge of investing in our own way, which borrows, I might add, from many of the master investors we know of.

Insider Monkey: What is your approach to investing?

What Cyril and I have built at Qualivian, and do every day, is simple … but not easy.  We try to focus on only a few good ideas that come to us irregularly and hold on to them, barring a change in the investment thesis.

– We cut out the noise …the majority of what passes for investment news in the general and investing media is noise, and very few decisions create most of the value over the long run.

– We focus on finding quality compounders and do not worry about which Morningstar box our portfolio is in.

– We do our own work. Conviction can only come from us. Everything else is speculation.

– When we find a quality compounder, we buy a lot of it. We do not dilute our portfolio and research process with low conviction names.

– We believe in concentrated portfolios. The goal of an intelligent investment process is to find situations where it is safe to concentrate. Diversification is driven by lack of conviction. Furthermore, academic studies have shown that one can accrue the benefits from diversification with 15-20 names

– We realize the human mind is designed to understand linear growth, not exponential growth. It consistently underestimates the result of consistent growth compounding returns over long periods.

– We seek to compound and do not feel the need to interrupt such compounding. We hold for long holding periods and trade rarely.

– We firmly believe that trees can grow to the sky… if you let them.

Insider Monkey: Why is it possible to buy quality compounders at a discount? Why are markets inefficient in this regard?

It is rare for quality compounders to trade at a discount, but since the markets have pockets of inefficiency, opportunities arise for several reasons.

– Market myopia: Markets focus on the short term, not the long term, so quality compounders with long term, visible value creation growth get inefficiently priced vs their long-term growth rates.

– Optionality: Many quality compounders have positive optionality which is not priced in. Investors focus on the visible and tangible. Firms with market dominance, plentiful cash flow, and innovative management continually think of new business possibilities that are less apparent but very possible. Investors should not just count the seeds in an apple but should also focus on the number of apples in a seed.

– Scarcity value: In an era of disruptive change, like today, the average stock will be more subject to disruption and investor estimates of their long-term earnings will be more likely to be mistaken. So, the scarcity value of stocks with wide moats, long growth runways, and resulting visible, sustainable economic earnings growth should increase because they are less likely to be disrupted. This is still not fully factored by the market into their valuation.

– Cognitive bias: Human beings are cognitively wired to think linearly. Quality compounders are subject to exponential growth, so existing valuation frameworks misprice them.

– Intangibles: Many quality compounders invest in potentially durable and long-lived intangible assets, which are expensed and not capitalized. This implies that GAAP earnings understate economic earnings. The stock is cheaper on economic earnings than GAAP earnings, but many investors miss this because they focus on GAAP earnings.

Persistence of High Returns on Invested Capital (ROIC): Quality compounders tend to have high ROIC’s. In the past, high ROIC’s mean reverted to average levels. However, around 2005 this stopped happening, and high ROIC’s have tended to persist for the top performing ROIC cohort. The causes of high ROIC persistence are industry consolidation, the emergence of platform businesses, the greater scalability of intellectual capital, changes in anti-trust policy, and other factors.  Many investors still reflexively assume that high ROIC’s will mean revert and have not factored high ROIC persistence into their valuation models. This undervalues high ROIC companies, which includes quality compounders.

Click to read the second part of this interview and see Qualivian’s top 3 investment ideas for the next 3 years.

Disclosure: No positions. This article is originally published at Insider Monkey.