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The process begins with a proprietary multi-factor model that screens our universe of approximately 2,900 small-cap public companies. The model is sector based and incorporates seven factors per sector that have proven to predict superior risk-adjusted returns within that sector. This filter is used to highlight stocks that are not only statistically cheap, but also have company fundamentals (revenues, margins, and asset turnover) that are showing early signs of improvement. Existing factors, as well as new factors, are periodically tested to ensure optimization. Typically, about 20% of the company universe will pass this screening process for further review. We believe incorporating quantitative tools at the front-end is very effective in quickly narrowing the universe and finding statistically cheap stocks with early signs of positive change. The analysts can then focus their attention on attractive candidates that meet our investment criteria.
The most attractively ranked stocks are then put through our fundamental discipline that is structured around a custom financial model. Our team focuses the majority of their time on this portion of the process - understanding the company, assessing its future, and evaluating information that can only be captured through in-depth fundamental research. We analyze the prospective investment for things such as its products or services, competitive advantages, barriers to entry, capital requirements, sensitivity to changes in key business drivers, and management quality. The objective is to find companies where the early fundamental improvement in free cash flow is sustainable and is not yet recognized by the market. We then continue the use of our custom financial model to calculate what we think the security is worth today. The model uses three separate and distinct approaches to determine the value of the business: 1) a discounted free cash flow calculation using our forecasts for the company, 2) a proprietary "returns-based" peer analysis, and 3) a method that assesses the cash flow returns and reinvestment opportunities. These projected values are then weighted with the greatest emphasis placed on the discounted free cash flow valuation. The bottom line to our purchase criteria is that a stock must trade at a significant discount to its intrinsic value and exhibit improving returns. u
Each potential new idea is then presented to the entire team for review. The members of the team challenge the investment thesis and forecasts for the company. Once a stock has been discussed from all angles and a buy decision has been made, its weighting is determined by the perceived risk for the company, its appreciation potential relative to other holdings, and the total weighting within that particular sector. For diversification and risk reduction, we typically hold between 55-75 stocks, positions sizes range from 1% to 3% at time of purchase (we will trim if the position size exceeds 5%), and we avoid making large economic sector bets. Our portfolios are fully invested; we do not attempt to time the market.
