We follow a strict quantitative and qualitative process. Investments must meet certain valuation criteria as we believe even great companies can suffer from poor returns if investors pay too high a price. Our valuation metrics remove emotional decisions from our research and force us to consider the potential upside as well as downside when making an investment. Large downside events can ruin years or decades of performance, and we believe a focus on valuation and company balance sheets lowers the risk of permanent downside. Once quantitative criteria are met, FCP researches company quality. As long-term holders of equities, we focus on how management allocates the cash on their balance sheet as well as cash from operations. Does the company have a competitive advantage that allows them to continuously reinvest in their business with high rates of return? This hunt for a superior incremental return on capital is core to our qualitative research process. When a reasonable valuation meets high business quality, FCP takes a position for clients and holds for the long-term.
On the sell-side, FCP frequently exits positions involuntarily. Mergers and acquisitions are part of modern finance, and often our research process unearths companies that are attractive to other players like larger enterprises and private equity funds. These acquirers offer a premium for our holdings, and shareholders commonly vote to sell. When our holdings are left to appreciate on their own, FCP will focus on valuation versus expected growth. If current valuation exceeds the company’s median high historical valuation, yet growth prospects have not materially improved, FCP will sell. Loss of competitive advantage, or significant misallocations of capital through management acquisitions are other reasons FCP will exit a position. Our long-term goal remains to invest in high quality companies at reasonable valuations and our sell discipline is designed to let winners run if they continue to offer great long-term returns.
Portfolio construction employs limits on individual position size as well as industry overlap between holdings. We are, however, benchmark agnostic. Most modern portfolios are built in the shadow of an index like the S&P 500. Even if the portfolio avoids “closet indexing” or holding nearly the same securities as the index, most portfolios are “benchmarking,” meaning if the index is holding 10% technology stocks, the portfolio will hold a similar amount, regardless of investment process. While benchmarking allows modern portfolios to avoid “tracking error,” or material performance differences from the index, FCP believes benchmarking can add massive unwanted risks to clients. If our investment process shows all energy stocks are trading at extreme valuations while deteriorating in balance sheet quality, we are going to allocate 0% to energy companies even if the index is 5%. A benchmarked portfolio will remain 5% in energy no matter what. Conversely, if there is a spectacular opportunity in healthcare companies, our process permits investing up to 25% of assets in a correlated group of ideas.
FCP casts as wide a net as possible and benchmark agnosticism facilitates this. We screen every profitable company above $100 million in market capitalization, and we can invest regardless if a company is included or excluded from an index. Furthermore, asset management is dominated by a few global, multi-trillion-dollar firms, and FCP has turned this into an advantage for clients. If there is a high-quality company in the sub $1 billion level, we can invest 5% of our clients’ assets in this opportunity without influencing the stock price or owning the entire company. Trees do not grow to the sky with size causing diminishing returns, and we believe most growth and extremely high returns come from smaller companies. Large asset management firms have limited their clients’ investment choices through their sheer size.
Finally, a comment on fads and flexibility. FCP has managed money through the late 1990s tech bubble and bust, the mortgage/housing bubble and global financial crisis, and currently in the 0% interest rate and passive bubble environment. Throughout all, we have left our investment process unchanged and been rewarded for our discipline during stock market collapses. With the benefit of this history, it is easier to say investment tenants should remain consistent in all market environments, however we have learned to be flexible in the types of investments we offer to clients. This is particularly relevant in the passive investing bubble of 2018-2020 when nearly every US equity failed to meet our preliminary valuation criteria. FCP had to adapt and search beyond equities for suitable investments, and our flexibility led to additional diversification and gains without compromising our principles on risk. While equities remain our first choice for long-term capital appreciation, we recognize the many, lengthy phases of mania, and have become more adaptable in our approach.
Discipline requires consistency to stick to an investment process in all market environments, confidence to adhere to investment principles when they are out of favor, and courage to deploy capital when markets are roiled. FCP demands these traits from its investment team. We believe our investment process is a rarity on Wall Street, and we are proud to offer our expertise to friends, family, and clients. Our mission is to show the world and share the benefits of how well a disciplined, fundamental investment process can work.