Torre Financial’s Investment Process
Top of the funnel, quantitive assessment, qualitative assessment, valuation, portfolio construction, and ongoing monitoring
A well-defined, structured investment framework is key to help investors make rational decisions.
While the market can be unpredictable, investors can rest assured that, if the foundation on which they are operating is sound, the outcomes should follow.
In this article, I’ll walk through my investment process including:
Top of the funnel - how I source ideas
Quantitative assessment - how I qualify ideas, to see if they are worthy of more research
Qualitative assessment - how I assess the likelihood of a company to continue growing and compounding for years to come
Valuation - how I assess the risk-reward trade offs and whether it is an appropriate time to build a position
Portfolio construction - how I consider the implications on my portfolio
Ongoing monitoring - how I incorporate and assess new information
Before diving into the details of my process, I want to provide some context about how I think and what I am looking to achieve with this process.
I take a long-term approach to investing. While equities may be volatile in the short term, longer holding periods have historically led to less variance in average annual returns. For example, average returns in any 1-year period may range from -26% to 52%, average returns over any 25-year period have historically ranged from 8% to 17%.
I look to invest in companies for the duration my thesis is kept intact. The target holding period is indefinite; it is determined by the progress, evolution, and stage of the company.
I look for emerging compounders and established compounders. I look for companies that are able to generate high returns on capital and reinvest that capital in attractive opportunities that are unique to their situation. I look to invest in the best companies and the best opportunities.
My perspective on risk is less about volatility and more about the permanent loss of capital.
I believe the uniqueness of any manager is manifested and expressed in how they invest. Some of my core values include discipline and excellence, transparency, continuous improvement and learning, simplicity and first-principles thinking, delayed gratification, and focusing on winners. I skew towards companies that are aligned with my own beliefs and interests, giving me additional conviction to withstand tough times.
Top of the funnel
I enjoy reading and learning about new companies. I’m constantly parsing incoming streams of information. I want to be aware of any new opportunities.
This broad, yet often shallow, part of the process gives me insights into a variety of different ideas, business models, and industries. This wide range of exposure enhances my judgement by giving me more perspective on possible trade offs in assessing companies.
While not comprehensive, the following list gives an idea of the various sources I use:
Articles from investor websites such as Seeking Alpha and Motley Fool
Newsletters and blogs such as Intrinsic Investing, Hhhypergrowth, Meritech Capital, Crossing Wall Street, and many more
Podcasts such as Invest Like the Best, The Investors Podcast, Masters in Business, The Business Brew, amongst others
Equity screening tools
My own work and life experiences, often looking up the parent company for a given service or product
Quantitative assessment
The purpose of the quantitative assessment is to qualify ideas for further research.
I analyze the company’s income statements, cash flow statements, and balance sheets over time, going back many years.
I want to see evidence of emerging or established compounders in the company’s financial statements.
Emerging compounders are companies with high revenue growth rates and strong gross margins. They may be investing heavily into their growth and therefore may not be profitable and may not have positive free cash flow.
Established compounders would reflect consistent revenue growth rates and high return on invested capital. For reference, return on invested capital is the product of the company’s net margin and their asset turnover ratio.
Growth is an important ingredient for a compounder, whether emerging or established. Revenue growth is necessary to achieve desired results. There’s a ceiling to gains achieved through cutting costs.
I look for healthy balance sheets, avoiding excessive debt.
When applicable, I assess the company’s GAAP earnings, operating earnings, and the conversion of earnings to free cash flow.
While there may be appropriate times for cyclical exposure, I have a preference for stability. I am most comfortable with stable compounding growth, consistently demonstrating forward progress.
The assessment of a company’s metrics is not an absolute, objective exercise. Rather, metrics need to be considered in relation to other companies. Different industries will have different company profiles. To fairly assess the metrics and quality of the company, it is appropriate to consider those metrics against comparable companies.
While I look for the metrics to clear certain hurdles, there is no fixed or hard cut off. Fixed cut offs, such as on the most recent data point or an average over a predetermined period, may unnecessarily eliminate worthwhile companies.
Given the above considerations, I exercise my own judgement to determine if further diligence is appropriate.
Qualitative assessment
The qualitative assessment is the perhaps the most subjective and time-consuming part of the process.
I review the company’s annual filings, news releases, investor presentations, investor events, and earning calls, amongst other inputs.
I analyze the company around five primary areas: core business, management & culture, market & opportunity, moat & competitive advantages, and risks.
Core business
I first look to deeply understand the business. I want to have clarity in the value they generate and how they make money.
I prefer stable, predictable businesses.
Management & culture
The products and offerings of a company may change over time. It is the management and culture of a company that drive that evolution.
I want to invest in people I trust. The decisions the management team makes and the culture of the company have a sizable impact on the company’s direction and ultimate outcome.
I look to invest in winners with a growth mindset.
I want the management team to be good stewards of capital and good capital allocators.
I have a preference for owner-operators, who often more readily choose the long-term over the short-term.
I look for a company to have the best interests in mind for all stakeholders including employees, customers, partners, and shareholders. This will help unlock innovation and future growth.
Market & opportunity
The company’s addressable market must be adequate for ongoing growth.
Is the addressable market sufficiently large and/or growing at a satisfactory rate? Secular trends, such as e-commerce and the shift to the cloud, will play out over many years. These are attractive markets because of their large size and ongoing growth.
Beyond assessing the current addressable market, I also consider opportunities for possible market expansions. What are their unique opportunities for reinvestment?
Moat & competitive advantages
The company’s moat, competitive advantages, and relatedly, their strategic positioning, have direct implications on the long term outcome.
This assessment involves understanding the businesses’ strengths and opportunities in relation to competitors.
How durable is the business? Will it be relevant in five or ten years? Why or why not?
Will their offerings be more or less valuable in five or ten years? Why?
Do they have pricing power? Will they be able to maintain their positioning for many years? Why or why not?
Conversely, are their offerings easily commoditized? Can other players enter their space and compete away their margin? Why or why not? How do they prevent this?
These are some of the open-ended questions that need to be understood to assess the long-term viability of a company.
Risks
As always, it is important to consider what might go astray.
I assess potential risks to the business, such as customer or product concentration. I take note of areas I want to keep an eye on.
Beyond immediate risks to the business, I also want to understand the underlying trends that influence the company. For example, a growth company may be exposed to interest rate risk and an energy company may be exposed to fluctuations in oil prices. Understanding what drives a company’s top and bottom line is an input to the upcoming portfolio construction assessment.
Valuation
My valuation assessment is driven by a combination of intrinsic valuation, i.e. the present value of all future cash flows, and relative valuation, i.e. current market multiples.
Because it depends on the future, valuation is subjective. Rather than build a precise, but perhaps inaccurate, valuation model, I prefer to keep it simple.
I use a simplified valuation model to understand the spectrum of possible outcomes.
I produce a sensitivity analysis varying key fundamental drivers and possible market multiples over time. I often use a five or ten year horizon.
Embedded with the prior quantitative and qualitative insights, this spectrum of possibilities allows me to assess scenarios and test assumptions as to where I think the company will be in the future.
What would have to happen to achieve 0% returns over the next 5 years?
Given low growth, what returns could I expect over the next 5 years?
This framework allows me to consider the relative likelihood of the possible outcomes.
I attempt to be conservative in my valuation assessment. I prefer to anchor my expectations on the lower end, rather than the upside scenarios.
I consider this my margin of safety. I want to protect against the loss of capital over time.
If the current valuation is not appropriate, I watch the company and wait for a better entry point in the future.
Portfolio construction
It is important to consider how this company could fit into my current portfolio.
Underlying factors
I look to invest in the best companies and opportunities. At the same time, diversification provides meaningful benefits.
While I may not seek to perfectly cancel out underlying risk factors (e.i. inflation or interest rate risks), I do want to be keenly aware of my exposure.
Replacing an existing holding
I keep my core holdings limited to 30 companies. Although an arbitrary number, I find it to be a helpful guide in terms of allowing for diversification but also forcing me to limit myself to choose amongst the best.
If I want to move forward with the current candidate and the portfolio is maxed at 30 holdings, I have to consider which holding I would replace. I assess trade offs against various existing holdings to determine which is the best.
Position sizing
Position sizes reflect my conviction in a particular company. My positions are not equal-weighted nor market-cap weighted. I do not arbitrarily rebalance.
Position sizing is likely to be fluid over time. It may change alongside valuation and/or other signals.
I keep changes to a minimum to reduce errors and taxes.
Ongoing monitoring
I constantly track the progress of the company. I monitor news, earnings, and other developments related to the company, competitors, and/or the industry. I reassess any of the above with any material changes.
If my investment thesis is no longer intact, I will re-evaluate the position.
Closing
This process can occur in a matter of days, but more often than not can take weeks or months, maybe even years.
I keep track of my thought process by writing things down. I write notes for every step of the process. I write down my investment thesis. I write notes about new developments and their implications on the company.
Every investor will have their own process for decision-making. There is no right or wrong answer. The key is to be able to understand and reproduce the process, even in times of confusion and uncertainty.
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Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
https://torrefinancial.substack.com
