Dev Kantesaria of Valley Forge Capital Management seeks companies with pricing power and operating leverage. Why Fair Isaac, ASML also fit the bill. By Jacob Sonenshine
Valley Forge Capital Management currently owns eight stocks, and rarely holds more than 20. The concentrated strategy, devised by founder and managing partner Dev Kantesaria, has worked well for the firm, originally based in Wayne, Pa., and now headquartered in Miami.
Kantesaria takes mostly long positions in U.S. stocks that he expects to outperform the S&P 500 over a number of years. The money manager looks for companies with ample operating leverage and minimal capital-spending needs, in industries with secular growth trends.
So far, so good. Valley Forge's hedge fund has returned nearly 15% annually since inception in 2007, beating the S&P 500 by more than five percentage points a year, according to a person familiar with the performance. Assets under management have grown to more than $3 billion from $500 million in 2019.
Barron's recently checked in with Kantesaria, who provided an update on his investment strategy and four of his holdings: S&P Global, Moody's, Fair Isaac, and ASML. The other four are Intuit, Aspen Technology, Mastercard, and Visa.
An edited version of the interview follows.
Barron's : How did you wind up in the money management business?
Dev Kantesaria: I've been thinking about businesses since I was a child. It's something that has always interested me. Even today, I can't go out into the world without thinking about how companies operate, and what separates a good company from a bad one. Initially, I wanted to be a surgeon. I attended MIT and majored in biology, and then went to Harvard Medical School. I realized in my third year of medical school that although I loved the intellectual aspects of medicine, practicing medicine wasn't something I could see myself doing for the next 30 or 40 years.
After I finished medical school, I joined McKinsey & Co. as a management consultant. Then I became a venture capitalist for about 18 years, working in the healthcare area. As a VC, I gained a tremendous amount of experience on the operational side of businesses, which is an important background to have as a public equity investor. Building businesses, being a director, working with CEOs, serving on committees -- all of that is helpful in assessing public companies.
Eventually, I wanted to create a vehicle to formalize my track record as an equity investor, so I launched Valley Forge Capital in 2007 with $300,000 and no specific plan. I expected to run a small fund for family and friends. Today we run close to $3.8 billion and have grown organically, mainly through word-of-mouth. We try to invest in high-quality businesses. Typically, they are large-caps.
How do you define a high-quality business?
We are focused on companies that are monopolies or oligopolies in their respective industries and have very few reinvestment needs. When companies have high capital expenditures or high levels of research and development expenses, the return on investment is difficult to predict. Our companies still have a tremendous amount of operating leverage, so profit margins can continue to grow over time with additional revenue and volume growth.
We also like to invest in industries with secular growth trends. When you combine pricing power with long-term organic volume growth, it is a very powerful combination.
S&P Global, Moody's, and Fair Isaac are longtime holdings. What, if anything, has changed in your assessment of these companies?
When you buy compounding machines that can grow organically at high rates for decades, there is low turnover in your portfolio. We first bought S&P Global in 2008-09, when the credit-rating services were under a lot of pressure. They were blamed for the financial crisis, and were the subject of almost 70 lawsuits. Congress was considering altering how the industry operated. The stocks traded at single-digit price/earnings ratios.
Beyond the noise, these companies had among the best business models in the world: rating debt. An issuer could try to use another rating service, but would have to pay 30 or 50 basis points more in interest rates. [A basis point is a hundredth of a percentage point.] Effectively, there is no way to undercut Moody's or S&P on price.
Can S&P Global lift its price over time?
Sure. We like to invest in companies where the cost of the service is small, so there is a lot of room for pricing power. S&P and Moody's both raise their prices every year at a rate above inflation. There was a lot of concern in the past few years about inflation as a macroeconomic risk. If inflation goes up to 10%, you want to know that your company can raise its prices 13%. They could double their prices tomorrow if they want to.
S&P Global is expected to earn $4.3 billion this year on $13.3 billion of sales. That puts the net profit margin at 32%. How much more margin upside is there?
All our companies can meaningfully grow their margins from what they are today. AI [artificial intelligence] will accelerate that trend because labor is the most expensive line item for most of the businesses we own. AI is slowly replacing labor. You could imagine that if you had 100 analysts at Moody's working in a certain area of ratings, you might need only 50 five or seven years from now, or maybe only 10. The bulk of the work could be automated and interpreted by AI. Operating margins could be 20% higher than the margins we were targeting before. You could see margins of 70% or 75% someday.
Let's go back to Fair Isaac. What do you like about the stock?
We have owned FICO since 2018. Its core business is consumer credit scores. When you apply for a mortgage, an auto loan, a credit card, the bank will run a credit background check. You'll receive a FICO score and that determines the interest rate you'll get. FICO operates as a natural monopoly. The entire ecosystem of consumer debt is centered around these scores. The company has a lot of pricing power.
Much of the world doesn't have developed credit markets. There is international growth potential.
What is the profit outlook for the company?
We think of free cash flow per share growth as the primary metric, correlated with intrinsic value growth. We expect free cash flow to grow more than 20% annually over the next decade. There is a lot of operating leverage in the scores business. We imagine revenue can grow in the low- to midteens, at least. The company is buying back 2% to 3% of its shares outstanding every year.
What else defines quality for you?
We want the companies in our portfolio to deliver high-teens growth in free cash flow per share annually on a weighted-average basis. If they do so, intrinsic value and ultimately share prices will roughly follow that growth rate. In last year's fourth quarter, the companies in our portfolio grew earnings by about 20% more than the S&P 500.
Most of our companies buy back stock every year. You don't have to assume crazy movements in sales or margins to triple earnings over a 10-year period. That works out to an average annual gain of roughly 12% a year.
The companies we invest in have many levers to pull, because not all of our assumptions will always be right. Maybe top-line growth for S&P or Moody's is lower than expected because debt issuance is down or interest rates went up. These companies can use their pricing power, or play with their cost structure. A cyclical company might have 30% or 40% earnings growth in a typical year, but then have negative growth. We like predictable companies. We try to look at growth rates over a period of 10-plus years.
Interest rates are the highest they have been in many years, even though the Fed is planning to lower them, probably later this year. What does that mean for S&P Global and Moody's?
Moody's and S&P had a strong year in 2020. As people worried about the economy shutting down during the Covid pandemic, many companies went to the market to raise debt to stabilize or increase the quality of their balance sheets. This year has started with record corporate-bond issuance. That creates a nice setup for Moody's and S&P over the next 12 to 24 months. As interest rates come down, we should see a resurgence in debt issuance.
Do the rating services still face regulatory risk?
Coming out of 2008, there were some learning lessons for these companies. Today the legal and regulatory risks are quite low. There are other approved firms to rate debt. Fitch is No. 3. Companies issuing debt can use any of the competitors. But a natural duopoly exists between Moody's and S&P.
Regulators talked about rotating ratings across different firms, and changing the business model so that the investors, rather than the issuing companies, would pay for ratings. Those are nice ideas, but in reality, none can be put into action.
What have you been buying lately?
We recently became owners of ASML, the semiconductor equipment company. AI is a strong growth story for the coming decade. Most AI technology will quickly become commoditized, and it is hard to know who the winners will be in 10 years. ASML seems the most exciting and predictable way to invest in AI.
The company makes machines that are about the size of a bus. They sell them for about $300 million apiece. They are the only machines in the world that can be used to make the cutting-edge semiconductors needed to power the servers for AI. Other competitors are probably 20 to 30 years behind ASML.
Thanks, Dev.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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