We are value investors. We do not seek to time the market, nor do we seek to closely mimic an index in our security selection. Our investment philosophy is that a portfolio of mid-to-large capitalization ($2 billion minimum market capitalization) quality companies purchased at attractive valuations will outperform the market and offer below-average risk over the course of an economic cycle.
Our core investment strategy focuses across five U.S. sectors we believe represent the greatest risk-reward opportunity. The financial, energy, technology, healthcare and utility sectors combined represent approximately 50% of U.S. public companies, yet 70% of U.S. public company profits.
Part of our differentiation is more accurately forecasting long-term earnings. We believe that earnings explain approximately 40% of the variance in stock price out-performance vs. the S&P 500. Our strategy is to identify and select the best of breed when valuations are attractive.
A core position is less than 15% of the portfolio, so that we would seek to hold about 15-50 companies spread across the five sectors. We believe recurring revenue and dividends lessen risk profile, yet many of the companies we target may be susceptible to inflation pressure. We use energy as a hedge against inflation with an energy weighting not expected to exceed 20% of the portfolio under ordinary circumstances. Because we are opportunistic and patient, we view cash as dry powder.
We define “quality” companies as those with strong, cash-generating business models, competitive moats, recurring revenue streams, and shareholder-friendly managements with a history of dividend payments. We apply a skill set developed from our careers in fundamental analysis to identify companies that meet these criteria, and to then opportunistically acquire shares in response to market movements that offer a compelling valuation.
Once an investment has been added to the portfolio, we continue to monitor the shares and ensure that the investment thesis remains intact. We target a multi-year hold period for investments, and we are prepared to own a stock longer if it remains a compelling investment year after year. A disciplined approach to prices paid in a focused, low-volatility strategy should provide a margin of safety, thereby reducing risk and preserving capital during market downturns.
In particular, while stocks with solid, steady business models may fail to keep up with the market during aggressive bull markets, we expect the portfolio to outperform during bear markets and to deliver above-market returns on balance.
We are fundamental analysts. Our research process is bottom-up driven. We use quantitative sector comparatives to select the companies that fit our investment strategy. From this list, we determine which companies that have the most compelling business models, demonstrated management execution, and attractive valuation.
The most compelling business models are discovered by reading annual reports, SEC filings, trade journals, and industry reports. Particularly important is analyzing competitors’ business models relative to our target investment. We analyze track records, insider ownership and visit managements when practical to evaluate effectiveness. To find attractive valuation, we create financial models to simulate earnings potential and risk as compared to alternatives.
Simply put, we research the business. We take a long-term view with our investments and select companies where we believe management is capable and shareholder-oriented.
Our portfolio stock selection is based on conviction and hinges on attractive valuation. With the exception of energy and cash, we do not have high water mark restrictions on sector weightings. Rather, we rank stocks based on conviction and add them to the portfolio based on valuation. If an investment value is too high or we believe a better opportunity exists then we replace the investment from our bench of investment ideas.
All purchase and sale decisions are the responsibility of the portfolio managers. The decision making process is a collaborative effort among the two portfolio managers and analysts within the firm. Analysts have significant input at all stages of the investment process.
Risk is a necessary component of investing, but we view risk management as one of our primary duties as a fiduciary. We focus on the equity market, which has historically been a great engine for wealth creation, but also home to booms and busts. Our goal is to generate long-term growth for our clients while mitigating the gyrations of the equity market.
We believe that risk in the equity markets can be mitigated by focusing on two criteria: defensive balance sheets and solid business models.
We prefer companies that maintain a cash balance larger than the minimum needed for operations and that minimize debt loads, which will hold up stronger in down economies. While they may “leave some money on the table” in up economies, they will tend to avoid catastrophic scenarios.
We target companies with business models that will still generate reasonably stable revenue even in down economies. We especially favor companies with recurring revenue, as it offers high visibility and minimizes the potential for sudden swings.
We avoid companies with “black box” revenue models that are difficult to understand and easy for managements to manipulate.
Our goal is to deliver a total return after fees that exceeds that of the S&P 500 index over the course of an economic cycle.
Given our specific sector focus, we expect to modestly underperform the S&P 500 during up markets and to outperform during down markets resulting in comparably favorable long-term risk-reward performance.
We believe valuation patience creates a margin of safety. A disciplined approach to prices paid in a focused, low-volatility strategy should provide a margin of safety, thereby reduce risk and preserve capital during market downturns.
We may have conviction about a particular business model, yet patience is key to finding an attractive valuation. Our bench is full of good ideas waiting for the right opportunity to be added to the portfolio.
Once an investment has been added to the portfolio, we continue to monitor the shares and ensure that the investment thesis remains intact. We target a multi-year hold period for investments, and we are prepared to own a stock longer if it remains a compelling investment year after year. We expect turnover to be less than 50% annually with a keen attention to taxes, as applicable to each client.
Although we intend to hold investments for the long term, we are consistently re-evaluating investments and comparing them to our bench ideas. We will typically sell for one of the reasons below:
- Valuation is higher than intrinsic value.
- The company has experienced a fundamental change.
- A better investment opportunity exists.