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How Are You Different?

Alpha is generated by being a little different in a disciplined and thoughtful way.

In a past article, How Much Are You Hurting Your Returns?, I highlighted how you can use inertia analysis to pinpoint the areas where your trading activity is hurting your returns. 

In this article I wanted to highlight a firm who on the surface looks like a traditional value investing firm. But when you dive below the surface you find a firm that has a very different and disciplined approach to actively creating alpha.  

Alpha is generated by being a little different in a disciplined and thoughtful way. 

I've been a fan of Turtle Creek Asset Management ever since a friend of mine and MicroCapClub member @Valueseeker123 brought them to my attention several years ago. I was reminded of them again after Andrew Brenton, CEO and Co-Founder, of Turtle Creek was interviewed by Clay Fink on the We Study Billionaires TIP Podcast.  

Turtle Creek has $5 billion in AUM and are value investors that hold 25-30 equities. They are trying to find and buy "generationally great businesses" far below intrinsic value. They “need” facetime with management because “90% of what we do is learning from management.” The firm has been fully invested except for the DotCom bubble. 

You are thinking, “this sounds like every fund pitch deck on the planet.”

Turtle Creek has compounded investor capital at 20% over the past 25 years.

You are now thinking, “Okay you got my attention. How are they different?”

That is the right question.  

Where Turtle Creek differs from most value fund managers is they actively trade around their core positions. They call it Continuous Portfolio Optimization. They buy more as the price drops from intrinsic value and they sell some as the price gets closer to intrinsic value. Their activity adds alpha to a pure buy and hold strategy. Here is a great video snippet with Andrew Brenton talking about their approach:  

87% of all global equities that went up 1000% or more over the past ten years were microcaps.

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As stock pickers, the way you invest is like a fingerprint. From a distance we might look the same, but when you zoom in we are all unique. There is no "this is the only way". In fact, your advantage is often in the areas you are different. Don’t be afraid to be unique. Be afraid if you’re not.

Here are more notes on Turtle Creek from this presentation: 

Four Step Investment Process

  1. Picking the right kind of company
  2. Valuation: Business (Intrinsic) Value
  3. Portfolio Construction: Sizing Positions
  4. Continuous Portfolio Optimization 

What Principles do you apply to searching out investment opportunities for detailed study? 

  • Meet everyone, talk to everyone and read everything of relevance.
    • We don’t run screens.
  • Apply pre–Turtle Creek Experience
    • Mergers and acquisitions advisors
    • Control of many companies across a variety of industries
    • We have seen inside hundreds of companies.
  • Seek to identify superior companies.
    • Honest and well-run
    • Founder/owner mentality
    • Integrity of management and board-alignment
  • Seek out highly intelligent organizations.

What kinds of information and securities are you seeking

  • Public equities (previously we were private equity investors)
    • Anglo Saxon rule of law (North America, Europe, Australia)
  • Information 
    • Access to management
    • Focus on Long-term

What Kind of investor irrationalities do you consider? 

  • We do not consider investor irrationalities in our process – but we acknowledge they exist.
  • Public markets are increasingly inefficient. 
    • Common behavioral biases (Loss aversion, recency bias)
    • Short termism (increasingly too much “information”
    • Agency effects
    • More and more passive investing
    • Over-valuing current yield
    • Artificial intelligence

What periods lead you to greater or lesser investments? 

  • We have always been roughly fully invested, only exception was 2000 (Dotcom bubble)

How do you define and estimate value? 

  • “Intrinsic Vlaue” based, present value of all future cash flows.
    • Same approach used by buyers of businesses.
  • Financial model built from scratch for each company.
    • Complex, flexible, nuanced, exhaustive, ever refining and probabilistic
    •  Over time our models become rich repositories of information and thinking
  •  Scenario Analysis
    • Make all assumptions explicit.
    • Test the future.
  • Frequent contact with management – focused on the business, not the quarter.
  • Approach allows us to generate a more informed view of a company’s intrinsic or Business value

How do you factor in asset values, related security transactions, industry economics, firm strategies, management behavior? 

  • We ignore related security transactions, while everything else referred to above is critical to our company valuation work.

How do you, if at all, account for differences between market prices and intrinsic values? What collateral information do you examine?

  • We don’t try to explain the difference because there is very often no correlation between market and intrinsic in the short term. 

How do you define and manage risk? 

  • Risk is being wrong in your forecast – risk is definitely not share price volatility
  • We manage risk through knowledge.
  • We construct our diversified portfolios of 25-30 holdings from those companies trading at larger discounts to value – the ones where very few scenarios result in bad outcomes, and most are good to very good. 
  • “Valuation risk” is the single biggest risk.

How do you make overall portfolio decisions and determine asset allocations? 

  • Collaborative investment team approach.
  • Portfolio weightings are chiefly determined by long term expected returns.
    • The larger the long term expected returns, from a combination of cash paid out to shareholders and the share price being “pulled” toward Business Value, the larger the weighting.
  • Additional factors include: 
    • Relative risk assessment (dispersion of forecast)
    • Quality of management
    • Alignment with shareholders
    • Context
  • Designed to achieve an optimized portfolio.

Continuous Portfolio Optimization (CPO) is a key source of historical outperformance and risk mitigation.

  • As prices change, long term expected returns change and the portfolio is no longer optimal.
  • In response, we incrementally take money from those holdings that are in market favor, where prices are rising and expected returns are therefore falling – and add to our investment in those that are out of favor – where prices are declining and expected returns are therefore increasing. 
  • This price to value discipline is used in all market environments and has not changed over the past 25 years. 
  • The price to value discipline reduces risk. 

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