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Unorthodox Value Approach from HCP Focus

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Stockholm (HedgeNordic) – Orthodox value investors have usually stayed away from asset-light tech companies, focusing on the quantitative and tangible aspects of a business instead. Finnish portfolio manager Ernst Grönblom (pictured), however, has applied many of Warren Buffett’s principles of value investing in building a highly concentrated portfolio of undervalued high-quality (mostly tech) businesses such as Amazon.com, PayPal, and others.

HCP Focus, one of the three vehicles under the umbrella of asset manager Helsinki Capital Partners, delivered an annualized return of a little more than 20 percent since launching in the last month of 2012. This return makes HCP Focus the second-best performing member of the Nordic Hedge Index (NHX). In a quarterly ranking compiled by BarclayHedge, the fund managed by Grönblom ranked among the world’s top ten equity long-only hedge funds in nine quarters out of the 12 previous quarters based on three-year annualized returns. No other competing fund joined the top ten leaderboard this many times during the period.

An outsider with little knowledge of Grönblom’s investing philosophy may well attribute his fund’s stellar performance to its exposure to high-flying tech stocks. But the manager does not just invest in any tech company. Out of the thousands of public businesses around the world, Grönblom searches for a select group of companies benefiting from a powerful economic moat: network effects.

First Things First: The Importance of Concentration

Grönblom’s stock selection process is paramount to the fund’s success so far, but there is one equally-important aspect of his investment process: portfolio concentration. Diversification is the only free lunch in finance and investing; few doubt that. But because of the false illusion that “more is better” in terms of diversification, “portfolio managers and money managers alike make the mistake of maximizing diversification instead of optimizing diversification,” reckons Grönblom.

“The academia and the investment management industry only talk about the benefits of diversification, but they never mention its downside effects,” Grönblom tells HedgeNordic. The most obvious downside of increased diversification is that one has more positions to monitor. “The investment community forgets that fund managers have a limited amount of resources at their disposal; the industry operates under the illusion that portfolio managers are super-humans who never sleep, never eat and can process an infinite amount of information in zero time,” says the portfolio manager of HCP Focus.

“The academia and the investment management industry only talk about the benefits of diversification, but they never mention its downside effects.”

With a typical calendar year consisting of 365 days, a portfolio manager managing a portfolio with 100 stocks can use three and a half days per year of his or her time to analyze one of these stocks, Grönblom’s back-of-the-envelope calculation reveals. A manager overseeing a ten-stock portfolio, meanwhile, has 36 and a half days to keep up-to-date with each investment. “Which manager is likely to make more informed decisions?” ponders Grönblom. Other adverse effects of excessive diversification include increased operating costs, portfolio dilution, among others.

As the portfolio manager of HCP Focus, Grönblom attempts to simultaneously maximize the benefits of diversification and minimize the downside effects associated with over-diversification. “In my opinion, you optimize diversification by maintaining a portfolio that holds between 10 to 20 positions.” Grönblom currently oversees a portfolio containing 12 names, but randomly investing in any 12 stocks out of thousands available in the market won’t do the trick.

Slow Traveling Idea: High-Quality Businesses Benefiting from Network Effects

In the attempt to populate his concentrated portfolio with successful investments, Ernst Grönblom searches for so-called slow traveling ideas. In contrast to simple and straightforward ideas, which require little expertise to evaluate, “slow traveling ideas require more expertise and more effort for their understanding than average ideas” reckons Grönblom. There is one slow traveling idea the portfolio manager likes the most.

“The most important slow traveling idea in my portfolio for a long time has been the concept of demand-side economies of scale, also known as the concept of network effects.”

“The most important slow traveling idea in my portfolio for a long time has been the concept of demand-side economies of scale, also known as the concept of network effects,” he continues. A network represents an accumulation of users or customers, whose value increases as the number of users or customers joining the network increases. “Digital network giant Facebook, perhaps, benefits from the most powerful source of network effects,” says Grönblom.

There is a good reason Grönblom focuses on companies that benefit from strong network effects. “Companies with sustainable network effects create winner-takes-all situations, where one company can end up dominating an entire industry due to inherent competitive dynamics,” explains the portfolio manager. “More often than not, companies with strong network effects create a natural monopoly for themselves.” Long story short, the portfolio manager looks for companies that have the potential to displace their competitors in the long term, thanks to the increasing power of their network effects.

Value Investing in Seemingly Overvalued Tech Stocks

Grönblom is always trying to identify and invest in superstar companies early on, and he has already achieved this feat on numerous occasions. He has owned Amazon.com for more than 15 years now and PayPal for more nearly 12 years even though HCP Focus was only launched in late 2012. Whereas investors have been offered the possibility to invest in HCP Focus in December of 2012, Grönblom had managed the strategy as part of a family office since 2004.

Grönblom is a value investor (perhaps an unorthodox one), and he attempts to buy high-quality companies at a significant discount to his estimate of their underlying intrinsic values. The portfolio manager uses the so-called economic value-added (EVA) approach to value businesses, arguing that this approach is “far superior to the discounted cash flow model,” for instance. “I have studied and compared different valuation methodologies for almost 20 years, and I have come to the conclusion that the EVA methodology is the most elegant both theoretically and conceptually, as well as the most intuitively clear,” says Grönblom.

“Market participants systematically underestimate and misunderstand the power of the winner-take-all phenomenon.”

Explaining why companies such as Amazon.com trade below their intrinsic values, Grönblom says “market participants systematically underestimate and misunderstand the power of the winner-take-all phenomenon.” Whereas tech stocks have commonly scared away orthodox value investors such as Warren Buffett, Grönblom continues his hunt for value in the narrow segment of the fast-growing technology space benefiting from network effects.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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