“Success is the sum of small efforts repeated day in and day out.”
– Robert Collier, author
The portfolio managers at Hemisphere are conservative, cautious individuals. We operate with a disciplined, but flexible, investment decision making process that stresses capital preservation and absolute, rather than relative, returns.
Our investment process has five broad stages, as follows:
- Macro Factor Analysis – We monitor and evaluate various global economic, political and social developments continuously.
- Theme Identification – Given our prevailing macro views, we then identify investment themes and/or secular trends impacting national and international financial markets and ascertain how these themes/trends will affect interest rates, economic growth, corporate earnings, currency trends, capital flows, relative yields between asset classes, etc. Our conclusions vis-à-vis these themes/trends drive our asset allocation decisions relating to appropriate client portfolio asset mixes as well as the duration/term-to-maturity of client fixed income portfolios.
- Sector/Industry Considerations – Often the identification of investment themes/trends highlights specific economic sectors or industries that have favourable prospects and those with a more challenging outlook. These conclusions help focus both our equity and fixed income security selection efforts.
- Security Selection – We undertake both a quantitative and qualitative analysis of every company we evaluate. In our opinion, analyzing a potential investment boils down to four basic tenets:
- Does the company have a sustainable competitive advantage; a competitive moat? Is it an industry leader and/or a low cost producer?
- What are the economics of the company’s business? How analyzable (straightforward and transparent) is the business? Is the business sustainable and adaptable? This is often reflected through above average, long-term dividend growth.
- What do the company specifics look like? Is the company financially sound? Does it have a strong balance sheet? How good is management? Is there a good track record of cash flow generation and reinvestment?
- On a conservative basis, what is the company worth? What is its “intrinsic value”? Ultimately, the intrinsic value of an investment is essentially a claim on an expected stream of cash flows that will be delivered to investors over time.
- Buy/Sell Decision– When estimating intrinsic value, we usually end up with a “range of fair value”. This range becomes the basis for both upside and downside price targets related to our buy/sell decision. We will only invest in a company when it is “undervalued” – i.e. the company’s stock price is less than or at the low end of this range of fair value. It is our belief that the share price of “undervalued” companies will, over a period of time, yield above average returns. Buying the shares of companies below their estimated worth tends to provide a “margin of safety” and, therefore, some protection during periods of weak stock markets. Stocks trading below their intrinsic value usually fall into one of the following categories:
- Fallen Angel – A good company that has suffered a setback (headline risk) creating an appealing valuation relative to its long-term growth potential. As the company “recovers” its valuation regresses to the mean;
- Hidden Gem – This is usually a smaller, “out-of-the-spotlight” company with unrecognized growth potential because it has yet to be broadly discovered by institutional investors;
- NAV (Net Asset Value) Play – A quality company trading with asset value potential not fully reflected in the stock price;
- Industry laggard – A company whose valuation is cheap as relative to other firms in the same industry; and
- Special Situation – a recent “spun-off” company, a post-bankruptcy firm, or a company currently undergoing financial restructuring whose intrinsic value is not recognized.
Although our intent is to remain invested for the long-term, our sell proposition is driven by the following considerations:
- “overvalue” – stock price has exceeded the upside of our fair value range;
- deterioration of the economics of the company;
- change in company specifics;
- new buying opportunity replaces a least attractive holding; or
- a “holding pattern emerges” – no positive developments materialize over medium term.
Reasons for “Under-Value” in Financial Markets
The stock market creates “value opportunities” for three reasons. Firstly, investors have historically overpaid for comfort and certainty. Investors like to buy the same stocks as other investors. Secondly, investors have historically overpaid for excitement or sex appeal. These glamour stocks are usually companies that are in the news and viewed as “winners”. Finally, in both a positive and negative manner, investors tend to overreact to major, but unlikely events. (Investors put too much emphasis on the outcome.) This is why investors overreact to news. Investors will reward a rapidly growing company too richly and punish poorly performing companies too severely.
Realization of Value in Capital Markets
Value is realized in the capital markets in essentially four ways. The most common is simple “regression to the mean”. Everything concerning markets and economics regresses from extremes toward normal levels and usually faster than investors realize. The perception of an undervalued stock will change from negative to positive over time. The second way is through a corporate takeover whereby the undervalued company is purchased at a premium by another company. The third way is through corporate restructurings whereby some type of corporate change (i.e. sale of a division) occurs that increases shareholder value. Finally, value is occasionally realized through a special dividend that usually involves a large cash or stock dividend.