Question: How do you define Value?
Answer: Value in my book is buying things for less than their intrinsic value. Intrinsic value is simply the current value of the cash flows that the company generates for its shareholders over time. Of course there could be situations where value could be unlocked by way of asset sales but those are by definition special situations and don’t come by every day.
In my experience undervalued businesses can be found at two ends of the spectrum. At one end the market may under appreciate sustainability of competitive advantages and/or the length of the growth runway for the company. These companies defy the norm of cyclicality and reversion to mean. At the other end of the spectrum there are companies that may be experiencing challenges due to cyclical factors, changes in the environment or their own past actions. But if the core business is healthy and a path to a better future (cash flows, return ratios) is visible then their depressed valuations offer an attractive entry point. The opportunity in both cases is buy something cheap relative to expectations.
This approach resembles a barbell approach.
Question: What’s your preferred approach? Top Down or bottom up
Answer: I like to combine both approaches. Investing is about buying good business at a price when it offers value and sitting still thereafter as the business delivers. But the market goes through waves in which sectors can experience de-rating and re-rating and this provides an opportunity to generate Alpha.
An important distinction to keep in mind is that the forces of mean reversion work on sector valuations much more strongly than they do on individual companies. In other words an individual company can experience a very differential outcome due to its competitive advantages but for the companies of a sector in aggregate the forces of mean reversion are rather powerful. This implies that the approach towards owning individual companies and sector weight has to be different. Valuations provide a prism through which one judges the attractiveness of sectors.
Question: How do you decide on the size of individual stock positions in the portfolio?
Answer: I prefer to manage the portfolio with all positions carrying an active positive weight. That is to say if the fund owns a company that is in the benchmark index- the position in the fund would be in excess of the benchmark weightie overweight. Otherwise the position would be zero. In other words the strategy would either be overweight an index stock or have a zero position. As for stocks that are in the fund but not in the benchmark, it is by definition an overweight position.
As a result the active risk in the strategy is high and performance deviation relative to the benchmark can also be high. This higher risk is consistent with a strategy targeting a higher Alpha.
Question: How important are forecasted earnings growth in your approach?
Answer: Growth in earnings is undoubtedly the source of wealth creation. But forecasting those earnings precisely is difficult and may even be impossible. That is the message from history. It is more important to monitor how a company is managing its competitive position and capital allocation rather than obsessing over consensus earnings expectations and changes in those expectations. Having a positive view on earnings is different from relying on precision in earnings forecasts.