The Highest Quality Portfolio You Will See - A Look Into Valley Forge Capital Management
The portfolio Valley Forge manages on behalf of clients is not your ordinary hedge fund portfolio. Only eight positions, 30% is stuffed into FICO stock, top 3 holdings account for nearly 70% of the fund, and most are in the financial services sector. That goes right against conventional Wall Street wisdom regarding diversification across companies and industries.??
However, Dev Kantesaria is anything but your typical Wall Street portfolio manager. The managing partner and co-founder of Valley Forge, Dev is a former Harvard-trained surgeon, McKinsey consultant and venture capitalist. In 2007, he founded Valley Forge with roughly $300,000 in AUM and a firm belief that a concentrated portfolio with only top-conviction ideas is the best way to outperform the market in the long run. Today, Valley Forge boasts more than $4 billion in AUM and has returned close to 15% annually since inception, per Barron's.??
Investment Philosophy
Valley Forge’s investment style is taken straight out of the Buffett-Munger playbook. That means, above all, an inherent focus on business quality and companies that can grow intrinsic value over time. According to Dev, this is the “easiest” way to make money in the stock market because it is more predictable and tax-efficient than other strategies.??
Another key aspect of Valley Forge taken from Buffett and Munger is the decision-making process. Most investment decisions are sourced from internal discussions and independent thinking rather than conferring with other analysts, which often just feeds into confirmation bias. The excessive focus on independence also includes staying away from Wall Street and New York City. While Buffett is based in Omaha, Valley Forge operates out of sunny Miami - the point is that staying away from the “crowd” eliminates group thinking and herd behavior.??
Compounding Machines
Valley Forge seeks to buy compounding machines. This term describes companies that can sustain high returns on capital over a long time and continue to reinvest at those high returns or return capital to shareholders; essentially, a long runway to grow intrinsic value. This comes down to returns on capital and predictability:
“We are never willing to trade reliability. We want very predictable companies that have strong organic growth and the ability to compound over many years, but to do it in a reliable way.”
These businesses are usually monopolies or parts of oligopolies in their respective industries. However, according to Dev, Valley Forge is not interested in companies where you “have to twist a customer’s arm” to use their services. Instead, a compounding machine is often a natural monopoly because of the value proposition it delivers to customers.?
Moody's and S&P Global account for 32% of the Valley Forge portfolio; these two companies have close to 80% market share in the credit ratings industry. If a company wants to raise debt or issue bonds, getting rated by Moody’s or S&P means lower interest rates on the debt. So even if a company could save money by getting rated by a different credit rating agency, the higher interest rates will likely exceed the initial cost savings. That is why businesses keep coming back to Moody’s and S&P and why they have a natural duopoly in the industry.?
Similarly, the cost of a FICO credit score on a normal mortgage is minimal. Some estimates suggest that the cost is about $1 on a $400,000 mortgage, and the FICO score gives the lender access to important information about the credit risk on the loan. So even if FICO’s costs were multiples higher, lenders would likely be happy to pay because of the value proposition.
Furthermore, Valley Forge looks for strong secular trends, pricing power, and operating leverage. For example, Visa and MasterCard benefit from digitization and higher e-commerce and cross-border spending, while FICO profits from higher data volumes to measure credit risk more accurately.??
The intense focus on predictability also leads Valley Forge to avoid many industries. That includes industries with no pricing power, such as commodities and airlines. Despite Dev’s background in health care, Valley Forge avoids biotech, medical devices and pharmaceuticals as well. These industries are simply not predictable enough when looking further than five years ahead.??
Capital Allocation
Valley Forge also puts a high price on capital allocation. While Dev has admitted that not investing in Google has been a mistake, he avoided the company because of the many investments into the founders' “pet-projects” and adjacent businesses with lower returns. The FAANG stocks also have unreliable R&D and capital expenditures, which have only intensified in the last few years. The fact that Valley Forge has outperformed the market without owning any big-tech (except for a small position in Amazon that was sold in 2023) makes the performance even more impressive.?
Interestingly, Valley Forge does not look for exceptional management as part of the investment criteria. Of course, Dev wants thoughtful and honest management, but he says that Valley Forge does not want to own businesses that “require Steve Jobs or Warren Buffett to run them.” That creates key-man risk, which makes the company difficult to predict. Again, the most critical role of a CEO is to get capital allocation right. That means either re-investing the capital back into the business at sufficient rates of return or returning the capital to shareholders through buybacks or dividends.??
Valuation
One of the most significant errors investors make is sacrificing business quality for valuation, Dev said in an interview in 2022. However, that does not mean you should pay any price for a high-quality business. Based on the most recent 13F filing, Valley Forge has reduced its FICO position over the past year as the valuation multiple has expanded to more than 50x earnings. Valley Forge typically holds a significant cash position “because we only put cash to work when great ideas present themselves.”?
The valuation framework is based on simplicity. Valley Forge calculates what the company’s free cash flow yield should be based on business quality and future growth, as well as the risk-free rate (because this impacts equity valuations). If a company is trading at a 30% discount to the estimated or expected free cash flow yield, Valley Forge sees a sufficient margin of safety.?
Conclusion
Valley Forge runs a highly concentrated portfolio inspired by Buffett and Munger. Some of the most important features they look for include:
One of the most important lessons for investors is that once Valley Forge finds a company that fits the investment criteria, Dev and his partners patiently wait for the right price. And once the price is right, they are not afraid to bet big on their highest-conviction ideas. In his own words, Dev Kantesaria spends 95% of his time reading about companies and industries, but also maintain models of companies on Valley Forge’s watchlist so that he can take advantage of opportunities when they appear.
This Newsletter's Author
This newsletter was written by J?rgen Pettersen. You can find him on?Twitter/X.
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