Founded in 1999 by Messrs. Adam Weiss and James Crichton, Scout Capital presently has about three billion US dollars in assets under management. Having been previous colleagues (both Mr. Weiss and Mr. Crichton worked as associates at Donaldson, Lufkin & Jenrette, and quit in 1996 to pursue their respective careers), both of them saw each other as a natural choice when the joined forces to launch Scout Capital. The chemistry of their personalities has also worked well for their investors: The firm has had annualized returns of 15.5%, compared to 0.9% by S&P 500, since August 1999 to December 2010.
Even though they had different backgrounds, Mr. Weiss was an art history major with a JD/MBA from Columbia while Mr. Crichton was a West Point engineering graduate who served two years in the Army prior to earning a Harvard MBA , they found common ground in their investment philosophies which they developed while running mock portfolios before establishing Scout Capital. The core investment values they resolved upon consisted of three major components: circle of competence, quality and misunderstanding.
Scout Capital seeks to find investment opportunities by combining a special situation approach, where the misunderstanding of the company’s stock is identified, with a focus on higher quality companies that possess incremental earnings power. To begin with the firm looks to underwrite companies that fall in their circle of competence, i.e. companies and industries that they understand. Expertise and contacts come into play in identifying a business and/or industry as investable.
Scout Capital concentrates on companies with long competitive-advantage spans giving the firm ample time to evaluate the businesses’ performance through both good and bad times. Over the years, the firm has expanded its circle of competence in divergent sectors and geographies, even investing in emerging markets such as Brazil and China.
The key elements in evaluating the quality of a company are pegged upon a business’ low capex requirements, its ability to generate high levels of free cash flow, and a preferential business model that enables the company to produce excess capital. Transparency of the financial and business models must be de rigueur, as should the value-add of the company’s product or service to its customers. Furthermore, from an industry perspective, long-term sustainable growth and secular tailwinds have to be viable constituents in forming the whole picture.
As far as the quality of management, both Mr. Weiss and Mr. Crichton agree that it is of the utmost importance and that there should be a degree of trust with the executives that they interact with to get a better idea of the business as a whole. The management’s methodology and focus should be in alignment with the company’s shareholders’ interests. So much so, that Scout Capital believes if the management’s compensation package is salary heavy and stock ownership light, then the focus tends to deviate from shareholder interest. For example a CEO with a salary higher than his/her stock ownership in the company, would inadvertently value his/her job more than the value of the stock. The CEOs in such a case would tend to adapt a short-term focus rather than strive for long-term gain.
Misunderstanding, which is the pivotal part of the firm’s investment strategy, is basically assuming a variant perception compared to consensus of a company’s earning power. Mr. Weiss and Mr. Crichton both refer to Joel Greenblatt’s “You Can Be a Stock Market Genius” for types of events – such as spinoffs, emergence from bankruptcy, and recapitalizations – where debt, equity or assets move around on a balance sheet leading to analytical complexity or some kind of irrational selling. A variant perspective may be the result of an introduction of a new product, or a change in management, or how operating or financial leverage may translate over a period of time. The prevailing factor in a differential view in all these cases is that some aspect of a company is changing which is being overlooked by the general consensus and hence, as Mr. Weiss points out, creating an “information asymmetry”. Identifying and giving this “disconnect” in perception gives Scout Capital the insight necessary to assess the misunderstanding about a business.
To give credence to this differential view, Mr. Weiss and Mr. Crichton have devised a variety of systems and reports which enables them to track, as mentioned before, the movement of debt, equity and assets around the balance sheet. This exercise together with running screens to identify companies with either being short on capital or having excess of capital, lays down the foundation of verifying and taking advantage of a latent opportunity in the company. To reach the stage of finding an investable company, the duo has developed an investment-committee memo designed to encompass all the core investment screens.
The memo is not a mere box checking drill but is there to ensure that all the procedural steps, developed over the years, are fully accounted for and analyzed properly. Once the memo has been distributed, an investment-committee meeting is held where everyone shows up armed with ideas, questions and analyses. The meetings, which Mr. Weiss refers to as “Fight Club”, offer all involved the opportunity to question, or to validate the proposed investment thesis in an open forum.
Over the years, Scout Capital’s portfolio has become more concentrated and more interested in quality. The founders’ direction stems from focusing and analyzing on the sources of previous returns and the belief that there are profound research advantages in concentration. The firm generally has a net exposure of 30% to 60% arriving at that net percentage by being opportunistic via utilizing cash, stock shorts, options and ETFs, as well non-equity instruments referred to as “insurance”. The firm tends not to use leverage.
As Scout Capital has the entirety of its financial net worth in the fund, it pays great attention to avoiding large permanent losses rather than to managing small oscillations in performance. The firm typically has between fifteen and twenty long positions while the number of shorts being in the mid to high single digits. Comparatively, the firm’s long portfolio has higher quality companies with lower leverage and the shorts tend to be lower-quality with higher leverage.
One of the best trades that the firm made was going long Google at its IPO while at the same time concluding that newspapers and Yellow Pages were great shorts. The firm ended up making more going short on the latter businesses than the returns from being long on Google. Even at the time of IPO of Google, the general consensus was that newspapers and Yellow Pages companies were still great cash-flow, deleveraging, high dividend concerns. Mr. Crichton refers to this as the “digital lawnmower” phenomenon, during which new digital practices superseded old non-digital business models.
As far as valuation is concerned, Messrs. Weiss and Crichton quantify outcomes above and below their base case. However, the base case valuation looks two years ahead at the estimated free cash flow applying it with a reasonable forward multiple. The mark being set at least 25% gross annual returns for any given investment idea. Referring to Warren Buffett’s thesis of a “company’s value moving through innovation, imitation and idiocy phases”, Mr. Weiss says he and the firm feel most comfortable at the initial stage as if they are writing the intellectual property. Even though the latter phases can be profitable, it just does not seem to be either one of the co-founders cup of tea. If they are echoing the consensus and something is no longer misunderstood, chances are they will be selling short.
“Like a lot of people our age we overestimated our competence and skill sets and decided we were ready to take over the world,”
“If you’re going to have a 10% position and you get it wrong, the consequence can’t be that it’s down 90%.”
“We’re much more comfortable in the early stages when we think we’re kind of writing the intellectual property.”