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Compounding machines, cigar butt stocks and the appeal of bond ratings agencies… Valley Forge founder Dev Kantesaria explains all

By Tanzeel Akhtar – High conviction investment ideas rule at Valley Forge Capital Management, a Wayne, Pennsylvania-based equity hedge fund manager with around USD450 million in assets. Here, founder Dev Kantesaria explains the firm’s ‘different’ approach to value investing and why there’s no place for ‘speculative securities’ and ‘ineffective financial engineering’ in the investment playbook…

Valley Forge runs a long-biased equity strategy and employs a rigorous, bottom-up fundamental approach to find the highest quality business models.  

Kantesaria (pictured) explains he analyses companies over a 10-plus year time horizon and looks beyond current earnings to focus on the long-term health of businesses. Valley Forge holds a concentrated portfolio of high conviction ideas (generally eight to twelve) and usually adds only one to three positions a year.  

“New positions must meet rigorous criteria for business quality, financial metrics and operational standards. Positions are typically liquid common stocks, although the fund may short opportunistically,” says Kantesaria. 

New positions are generally added at a 30 per cent to 60 per cent discount to Kantesaria’s view of intrinsic value. Valley Forge seeks to buy companies that are “compounding machines,” which can grow their intrinsic values over a multi-year period. Historically, this approach has led to low portfolio turnover and improved tax efficiency.

Valley Forge does not directly hedge its portfolio through put positions, or what Kantesaria views as other forms of ineffective financial engineering.  

The fund manager explains he aims to control risk through investing by minimising the use of leverage at the fund level while avoiding companies with stretched balance sheets. He avoids speculative securities such as commodities, currencies, futures and other similar derivatives; and also holds a highly liquid portfolio with the ability to rapidly sell or exchange securities when company circumstances change or during periods of high market volatility.  

Kantesaria explains that Valley Forge practices value investing very differently to most of its peers. When asked how so, he says he avoids the “cigar butt” stocks, which look cheap but are in fact value traps. “These companies generally lack organic growth, and their business quality rarely improves, even in the hands of strong management,” says Kantesaria. 

Kantesaria explains that instead, he looks to purchase high-quality businesses, which have pricing power, operating leverage and capital efficiency. He believes such companies can thrive in a variety of economic conditions. Kantesaria’s approach seeks to reduce the need to market-time around macroeconomic factors, which are difficult to predict in the short term.”

Despite US equities hitting record highs in recent weeks, Kantesaria still finds significant value in the current marketplace. He likes a number of companies in the software/IT, financial services and payments sectors.  

The current portfolio is close to fully invested (99 per cent stocks/1 per cent cash). Such high net exposure reflects Kantesaria’s enthusiasm for the strong operating performance he expects from his companies in the coming years.  

Kantesaria remains bullish on equity prices over the long term, which he believes will likely be supported by a prolonged period of low interest rates.  

Earlier this year, the Federal Reserve changed direction on interest rate policy, causing 10-year US Treasury yields to decline from 3.2 per cent in November 2018 to about 2.1 per cent today. Kantesaria believes that trends in automation, artificial intelligence, and cloud services could lead to higher unemployment, forcing the Federal Reserve to keep interest rate policy accommodative for the foreseeable future to spur growth and employment.  

Since bonds and stocks compete for investor capital, lower interest rates put upward pressure on equity price-to-earnings multiples, which causes company earnings yields to more closely align with bonds. Multiples on US equities have already increased from recent lows seen during the market downdraft in late 2018. Kantesaria believes that companies with predictable and growing earnings will become highly prized assets in a low interest rate environment and benefit the most from rising price-to-earnings multiples.  

Prior to founding Valley Forge in 2007, Kantesaria spent many years as a venture capitalist. Through his work with private companies, he explains that he gained valuable insights into assessing management teams and company operations. He believes this experience gives him an advantage when assessing the actions of publicly-traded companies.  

Kantesaria contends that temperament and discipline are keys to superior investment returns. He says that patience and remaining unemotional through market swings allows Valley Forge to take advantage of opportunities when others are irrational or fearful.

Valley Forge focuses its investment criteria in a number of areas: business quality, predictable earnings, capital efficiency and prudent management. 

Kantesaria looks for companies with leading industry positions, durable competitive advantages, scalable business models, significant operating leverage and earnings not overly affected by extraneous or unpredictable factors. 

“Such businesses should deliver strong organic growth over a multi-year period, employ pricing power, operate in an industry with positive volume trends and have flexible cost structures to maintain margins during down periods,” says Kantesaria.  

Valley Forge seeks out companies that can generate attractive returns on capital, have low capital expenditures and R&D costs, use limited leverage and efficiently deploy free cash flow.  

Finally, Kantesaria wants to see an ownership structure that aligns management with the shareholders through appropriate compensation and incentives, superior governance and rigorous reporting standards, all of which should encourage better capital allocation.  

One company that represents many of the firm’s investment ideals is Moody’s Corporation (ticker MCO), which has been in the Valley Forge portfolio for over 10 years. Kantesaria first bought Moody’s during the 2008-2009 financial crisis, when negative publicity, regulatory threats and litigation hammered the company’s shares.  

Moody’s operates in what is essentially a duopoly with S&P Global. These companies together rate more than 90 per cent of the bonds worldwide. Kantesaria believes that the bond ratings business is one of the best business models in the world. 

“Moody’s has strong pricing power it can consistently raise its prices above the rate of inflation, strong operating leverage its margins increase with higher revenue, and is highly capital efficient very little of the free cash flow needs to be reinvested back into the business, says Kantesaria. 

Bond issuance volume has meaningfully grown over the last ten years and will be aided in the future by the maturing debt markets in China and India as well as bank disintermediation and the rise in private debt markets in Europe. Since early 2009, Moody’s shares have risen more than tenfold.  

Valley Forge charges a 1 per cent management fee and a 20 per cent performance fee over a high-water mark. Until the fund reaches USD500 million in assets, Valley Forge is offering a discount to this fee structure for allocations of USD25 million or more.

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