Equity Investment Philosophy

Our investment process for the Small Cap Value Portfolio is based on the philosophy that investing in durable companies with growing earnings at value prices is an effective way to build and preserve capital. We believe that managing risk is the key to delivering superior long-term investment results. Therefore, before we consider how much we might earn on a new investment, we always consider how much we might lose.

To determine the universe of stocks that we will consider for research we utilize the following methods:

  1. Quality and value screening of stocks with a market capitalization of $7 billion or less.
  2. We also draw new investment ideas from industry trends, investment themes, third-party analyst recommendations, and news and trade journals.

In identifying possible investments for the portfolio their approach is to think like an owner.  Stocks represent fractional ownership in real businesses. The firm’s investment process emphasizes fundamental research, using both quantitative and qualitative techniques. We look for characteristics that, in their experience, foster long-term value creation including products or services that do not become obsolete, financial strength, high returns on capital, sustainable competitive advantages, and proven management.

Ultimately, we attempt to build a short list of businesses which would represent compelling investments if we could purchase shares at favorable valuations.

The inception date for the Small Cap Value Portfolio is 09/01/2012.  The portfolio has been co-managed by Adam Zuercher and Anthony Hixon since inception.

Investment Decision-Making Process

Once a company has been identified as a candidate for the portfolio, we adhere to a rigorous research process.  We conduct extensive research into company fundamentals, reviewing financial statements, regulatory documents, and third party research.

The things we look for in a company include:

  1. Strong Economic Moats – We define an economic moat as a company’s competitive advantage. Just as a moat protects a castle from invaders, an economic moat works to protect a company’s profits.  Some examples of economic moats include:
    • Non-obsolescent products or services
    • Dominant or growing market share
    • Participation in a growing market
    • Global presence and brand names
    • Smart application of technology to improve business and lower costs
  2. Strong Financial Condition – A quality company should have a strong financial condition. Welook for companies that have a strong balance sheet.  Strong finances give a company staying power to weather difficult economic cycles.
  3. Strong Profitability & Growth – Because earnings drive a company’s value, we believe that a quality company will have a history of consistent earnings ability. A quality company also has the ability to grow their earnings.  We seek companies that have been able to consistently grow their earnings and have a reasonable expectation to continue to grow their profits.  An ideal investment will exhibit a powerful combination of high return on equity and high free cash flow.
  4. First-Class Management – A great business will be run by managers who have a proven track record with significant personal ownership in the business. We will also run the company for the benefit of the shareholders.
  5. Reasonable Valuation – We believe that purchase price is a critical component of an investor’s total return. Before purchasing a company we determine if it is trading at or below our calculation of fair value. When assigning a valuation to a company we consider traditional valuation ratios such as price-to-sales, price-to-earnings, price-to-book. In addition, their fair value calculation includes a review of the earnings yield or free-cash-flow yield and a discounted cash flow analysis. Valuation analysis is crucial, and therefore to avoid falling into the trap of using only one or two narrow measurements – such as price-to-earnings, price-to-book, dividend yield, or price-to-sales – we utilize a number of tools to build a comprehensive picture of the underlying value and associated risks.

Portfolio Construction

The Small Cap Value Portfolio is a concentrated portfolio investing in 20-30 securities. To control risk, we have placed the following limits on the portfolio:

  1. No more than 25% in a single industry.
  2. No more than 10% in a single position.
  3. All of the stocks selected should have a market capitalization of $7 billion or less at time of purchase.

An initial stock purchase will be in increments of 2% to 5%.  Actual position sizes are determined by the portfolio managers and vary based on our level of conviction in the investment, the number of existing positions in similar industries, and the amount of cash available.  As holdings rise in value, we will limit the weight of a single holding to 10%.

We do not look to the benchmark when making investment decisions.  We do monitor their sector weights relative to the benchmark for informational use only.  Investment decisions are bottom up and are not managed relative to the benchmark.  We may seek to weight a specific sector more heavily to capture current economic and investment trends, or on the other hand we may avoid certain sectors altogether.

We will sell a stock for any of the following reasons:

  1. Misinformation – If we discover new information that is detrimental to the company that was unavailable at the time of purchase we may sell the company.
  2. Deteriorating Fundamentals – If a company’s business fundamentals are substantially worse than we used to be with signs of continued deterioration, then we may sell the company.
  3. Detrimental change in management or focus of the company.
  4. Overvaluation – If a company’s stock price has risen above our estimate of fair value we may sell the company.
  5. Better Opportunities – We may sell a stock if we determine that capital could be reallocated to a more attractive stock.
  6. Overconcentration – We may sell a portion of a position if it becomes over-weighted in the portfolio.