A disciplined framework for finding and following investments.

Early-stage equities are low-revenue, small- or micro-cap, and often pre-profit businesses that nevertheless present an interesting investment proposition worth monitoring.

I often encounter these companies through investor events, research or industry networks. The potential can be compelling, but the uncertainty may remain too great to justify immediate investment. This category can include early-stage mining companies, biotechnology businesses, technology companies and other smaller enterprises with significant growth potential.

I also place some established but pre-profit businesses into this category: companies with meaningful revenues but which have not yet demonstrated durable profitability.

My usual approach is to add the company to the watchlist with clearly defined alerts. These might be triggered when a business reaches a particular revenue or EPS threshold, or when subsequent RNS announcements provide evidence that the investment case is maturing.

Deciding when such a business deserves a place in the portfolio is closer to the art of investing than the science. The following disciplines therefore remain particularly important:

• Only invest where there is an appropriate margin of safety.
• Look for evidence of a credible record of growing earnings, assets or underlying economic value.
• Require a potential return commensurate with the risk being assumed.
• Consider whether inflation, interest rates or financing requirements could undermine the investment case.
• Avoid businesses where permanent destruction of capital remains a plausible central outcome.

Market Leaders are established, profitable businesses that occupy leading positions within their industries. They typically possess meaningful scale, established earnings, healthy returns on capital and, in many cases, a record of returning cash to shareholders.

Identifying these businesses is comparatively straightforward. Benchmark indices, sector leaders and the holdings of accomplished fund managers provide useful starting points from which to identify the strongest businesses within a particular industry.

The more difficult question is valuation. These companies frequently fall into the category of “great business, wrong price”. I therefore place them on the watchlist with the principal trigger being a material change in valuation, usually through a fall in the share price or an improvement in underlying earnings.

This approach reflects my belief that even an exceptional company can produce a disappointing investment outcome if purchased at an unreasonable price. These businesses form much of the foundation of my portfolio and sit behind my preference to begin with a broad market and then concentrate capital in the businesses I judge to be strongest.

• Understand the sector and the underlying business as thoroughly as possible.
• Consider what would make the investment thesis wrong and how that would affect the value of the business.
• Guard against false certainty and overconfidence; no investor has complete information.
• Distinguish value from price. Scale and reputation alone provide no guarantee of a satisfactory return.
• Approach the company primarily as a business analyst, rather than attempting to forecast every macroeconomic variable.

Special Situations are businesses facing unusual corporate events or temporary disruption. They are the rarest entries on my watchlist and can include event-driven or arbitrage opportunities.

Such opportunities can arise from mergers, tender offers, spin-offs, liquidations, rights issues and other corporate actions. The potential return often exists because the market assigns a discount to an uncertain outcome.

Consider a company subject to a takeover offer. Until the transaction actually completes, it may remain dependent on board, shareholder, financing or regulatory approval. The target company’s shares therefore commonly trade below the agreed offer price. That discount can narrow or widen as the market reassesses the probability of completion.

An investor may seek to benefit by buying at that discount and waiting for the transaction to complete, at which point the spread closes. The risk is equally clear: if the deal fails or its terms change, the investor may be left owning an asset whose valuation was supported principally by the anticipated transaction.

One example was Microsoft’s proposed acquisition of Activision, announced in January 2022. The transaction faced significant regulatory scrutiny and opposition, including concerns raised by Sony in relation to Microsoft’s gaming interests.

During the process, Activision shares traded at a material discount to the agreed acquisition price. Investors willing to assess the regulatory and completion risks could purchase the shares below the deal price and wait for that spread to close if the acquisition succeeded.

• Identify precisely what event must occur for the investment thesis to succeed.
• Quantify the potential return from successful completion against the likely downside if the event fails.
• Treat regulatory, financing and counterparty risk as central to the analysis rather than peripheral details.
• Avoid allowing the apparent certainty of a contractual offer to obscure the possibility that circumstances can change.
• Keep position sizes proportionate to the binary or event-driven nature of the outcome.