Overlook Investments is a Hong Kong based investment fund with ~US$4bn of assets under management. The firm was started by Richard Lawrence in 1991. The fund invests in public equity markets across Asia (excluding Japan) and holds a concentrated portfolio of 20 or so holdings. Since inception, the team has compounded capital at a mid-teens rate of return, a remarkable track record over 25 years.
There is an excellent talk by Richard Lawrence in 2015 that has been made publicly available by the Benjamin Graham Centre at the Richard Ivey School of Business. In the video, he outlines the firm’s investment model as well as his underlying investment and life philosophies. For those who have the time, it’s well worth a watch. In case you prefer an abridged version, below is an outline of the model as well as some key takeaways. Just to clarify, these are based on my own notes and understanding of his talk.
The Overlook Model
Overlook follows a simple investment model that consists of four pillars:
- Pricing power: Companies with pricing power have the ability to maintain their profitability during periods when input prices are rising or falling. To understand the extent of a company’s pricing power, Overlook focuses on cash gross profit margins (excluding depreciation) over time. Ideally, one wants to find companies with high and stable margins, meaning there is little variability in this number over time. Lawrence mentions Want Want China Holdings and the Taiwan Semiconductor Manufacturing Company as examples of past investments with demonstrated pricing power.
- Cash flow: Lawrence says the cash flow statement as it’s typically presented is the most “abused” of all the financial statements. Instead, to get a clearer picture of a company’s cash flow, Overlook calculates four separate metrics: gross cash flow, free cash flow, cash flow of the corporate structure and working capital cash flow. Plenty has been written about accurately calculating cash flow numbers, but perhaps his most interesting insight relates to cash flow of the corporate structure. Here, Overlook likes to map out the organization in detail to understand where exactly the company’s cash and borrowings reside. He says failing to do this often trips investors up because they don’t have good visibility into how easily cash can move through the organization. He cites the example of Apple having to borrow domestically to pay dividends because the majority of its cash is overseas. Overall, in evaluating cash flow, he looks for companies that have high operating returns, negative working capital (“free equity”) and relatively low reinvestment requirements.
- Profitability: Overlook’s preferred tool for analysing company profitability is the DuPont model. For the uninitiated, that’s the formula that breaks down return on equity into its constituent parts: profit margin, asset turnover and financial leverage. Using the DuPont model allows an analyst to delve deeper into the specific drivers of return on equity for a company (ideally, it’s driven less by leverage relative to the other components). The other metric they look at is operating return, which is calculated as EBIT over the net assets of the business. Lawrence likes to see if high operating returns translate into high return on equity, which is a reflection of a high quality management team.
- Valuation: Lawrence likes to use data and formulas to take the emotions out of investing. He mentions the Graham number (named after Benjamin Graham) as well as a formula devised by John Neff as two useful measures of valuation. He has also come up with his own formula to determine the target P/E of a company. He takes return on equity + normalised earnings growth divided by 4. So, for example, a company with 20% return on equity and 15% normalised earnings growth would have a target P/E of ~9x. He is a big believer in regular re-balancing in order to ensure the structure of an investment portfolio is correct.
Investing & Life Lessons:
Stick with cash flow positive countries: Lawrence says you can get in trouble when money starts flowing out of a country quickly. Overlook experienced this during the Asian financial crisis of 1997/8, but he sees this happening again in a number of emerging markets today. By contrast, many countries in Asia are cash flow positive today, having learnt their lessons from previous crises. The other macroeconomic indicator he keeps an eye on is total loan growth – a good bank can reasonably grow their loan book by about 7% on an annual basis, but above that he starts to get worried.
Being a contrarian is important: Value investors must have the fortitude to step up and buy in bear markets, but this behavior doesn’t come naturally to most human beings. If you feel uncomfortable when buying a stock, then you are probably on the right track, but you always have to find your own margin of safety. At the end of the day, this often boils down to valuation and making sure your companies have the financial strength to get through difficult periods.
Invest in market cap appropriate stocks: One interesting point Lawrence makes is that Overlook only invests in companies with a market capitalisation greater than the fund’s AUM, in order to ensure they always have the liquidity they need. Being caught in market cap inappropriate stocks can sometimes get investors into trouble during bear markets.
Find your investing “cousins”: The great thing in investing is that you don’t have to know people personally for them to be your mentors. A number of great investors have written books, annual letters etc. that are publicly available. There are many different investing styles out there, but it’s most important that you find your “cousins” – people who do things in a way that make sense to you.
Outlaw the greed: Lawrence ends by saying that if you can be a good investor for 8 years, you will have all the money you need. Let the next person be the greedy one. You should do it because you love the process and challenge of investing.