Process at a Glance
Our investment process combines top-down value/growth ("Value/Growth"), large/small market capitalization ("Large/Small") and sector ("Sector") allocation with bottom-up stock selection, and includes fundamental, technical, behavioral and pattern recognition elements. Large/Small and Value/Growth allocations are derived through statistical analysis designed to assess and follow ongoing cyclical evolution of currently prevailing investment preferences. This analysis is overlaid by fundamental evaluation of macro-and micro-economic backdrops that we believe may affect further evolution of market preferences. Bottom-up analysis is based on quantitative evaluation of reported financial performance by thousands of companies representing various sectors of the U.S. and global economy. Various third-party research and ratings contribute to the bottom-up selection process, allowing the investment team to follow the evolution of investors' views on different companies. We supplement the quantitative input with a qualitative overview of each position in the portfolio. The strategy, which consists of 36+ stocks, could have a substantial sector bias in comparison with our composite benchmark (S&P 500 80% and Russell 2000 20%), and is aligned with major themes in the market.
Top-Down Approach: All Market Cap, Value/Growth and Sector Strategy
Value/Growth and Large/Small Cap Cycles
We use the Return based style analysis pioneered by William Sharpe and recognize that there are distinct cycles in the market-place driven by certain style axes (such as large/small, value/growth). The team employs changing cycles in which large vs. small and value vs. growth companies outperform/underperform as two major forces among the drivers influencing investment return. We follow the cycles in our portfolio management, but do not try to predict them. We believe that size cycles are usually much longer than style cycles. From our past experience style cycles (VG) run from 12 to 24 months while size cycles could extend up to 6 years. We use the size and style cycle analysis to adjust our portfolio postures.
Sector and Industry Allocations
In order to determine our Sector weights we use a combination of Russell 1000 and Russell 2000 Value and Growth Indexes. We decompose the sector allocation of the benchmark indexes and then tilt the weights of the Sectors based on our Value/Growth and Large/Small postures. So, we get the initial Sector composition based on simple weighted sums of each Sector's weight in one of the four indexes. Then we adjust Sector weights taking into consideration economic cycle (GDP growth, contraction, etc.) and our wrap-up Sector Rating based on the underlying individual stocks' average ratings included in a particular Sector. We generally do not allow a deviation of more than 10% from the composite benchmark. The ten sectors we work with are: Consumer Discretionary, Consumer Staples, Energy, Financials, Healthcare, Industrials, Information Technology, Materials, Telecommunications and Utilities. Each Sector consists of multiple Industries. The 100 Industries we use are assigned a proprietary Industry Score, which allows us to diversify within the broader 10 Sectors, picking up individual positions that we believe to be in the most attractive industries.
Investment Regime Considerations
In our opinion, liquidity becomes a very important factor to consider especially in light of central banks around the globe relying on monetary policy to spur the economic growth and avoid stagnation. We believe that in a low interest rate environment the market participants have to adjust their assumptions to their valuations, making liquidity an important factor to consider. Safety/Risk on and off periods in the market shape up the investor preferences and those periods can be of a considerable length. We also believe that taking into account different volatility regimes can be crucial for portfolio composition. For example during the risk off period we could take a more defensive Large Cap Value posture, while during the risk on environment we could add some more Small Cap Growth flavor to the portfolio.
Bottom-Up Approach: Ranking System of Individual Stocks
Based on our multifactor models we score close to 3,000 US and Global companies in our universe and strive to identify attractive investments by comparing them to their peers by Industry and Sector.
We observe how markets reward broader factor groups (value, growth, safety, profitability, technical and behavioral), and endeavor to understand how the market shifts its preference from one group of factors to another, in a particular economic sector and the strength of the shift. We use a combination of third-party ratings in order to reinforce our internal analysis. The third-party ratings we use belong to well established providers with several decades of history and industry wide recognition. The way we combine the ratings with the fundamental factor groups aids our understanding of the market's preferences in relation to intrinsic value of individual companies we select for our strategy.
Factors in the Multifactor Models
When we build our multifactor models we consider different time periods and investment regimes. The major types of factors are listed below.
We include price-driven factors from accounting statements. We believe that Price/Earnings in different variations is among the most fundamental measures of a stock's valuation. The more earnings for every dollar invested, the more value the security represents. Multiples of earnings and assets are discriminating measures of relative value. The same holds true for multiples of sales. We would not consider these factors on a stand-alone basis. We believe that a company with no growth prospects could have a comparatively attractive valuation but justifiably so and would not represent a good investment candidate.
Earnings, sales growth and consistency become a very important part of all our models. The dynamics of growth rate, consensus expectations and magnitude complement the discriminatory analysis of all stocks in our universe.
It is important to understand how effective each company is in using its resources. Measures like Return on Assets and Return on Equity are among the factors we use to assign the probability of the companies outperforming their Industry group peers.
Banks do a very thorough analysis of borrowers financial health and we piggy back on their work when it comes to assessing the financial health of an individual company. The better the internal financial discipline, the better chances are that the company can sustain rough patches in the future. We incorporate 3rd party credit analysis and volatility statistics to assess the safety of each individual stock.
We believe that momentum factors are important indicators of future success. Relative price strength and stability along with growth dynamics support performance in short and medium time periods.
Institutional ownership and accumulation/distribution of an individual position among sophisticated investors could be a strong indicator of future performance of the stock. We believe following "smart money" can be a worthwhile strategy.