Our investment strategy is designed around the changing hierarchy of the three determinants of equity investment returns: earnings, dividends, and P/E ratios. Throughout history, the relative importance of these three determinants has changed dramatically depending upon the economic landscape of the period in question. In the 1980s and 1990s, for example, rising P/E ratios were the principal drivers of equity returns, leading to the popularity of valuation methodologies that reflected price-to-book value and price-to-earnings metrics. Underlying this 20-year P/E expansion was a collapse in interest rates.
We believe we have entered a period in which P/E ratios are more likely to contract than expand as interest rates begin to rise rather than fall from their recent historic lows. Given the inverse relationship of P/Es to interest rates, P/E multiple expansion will cease to be the primary explanatory variable of equity returns, leaving earnings growth and dividends as the main drivers of equity returns. These two drivers come from a single source: cash flow.
Components of Compound Annual Equity Returns for Trailing 10-Year Periods (S&P 500 Index 1936-2014)
Consequently, Epoch’s security selection process is focused on free-cash-flow metrics as opposed to traditional accounting-based metrics. In our view, the key to producing superior risk-adjusted equity returns is the identification of companies with a consistent, straightforward ability to both generate free cash flow and to properly allocate it among internal reinvestment opportunities, acquisitions, dividends, share repurchases and debt pay downs. The relevant factor in management’s decision on how to deploy free cash flow is the cost of capital. Acquisitions and reinvestments should only be undertaken when the return on incremental capital is greater than the firm’s average cost of capital. Otherwise, it should be returned to shareholders via the other three uses: dividends, share buybacks and debt repayments. Epoch defines these three uses as “shareholder yield.”
At Epoch, we strive to produce superior risk-adjusted returns by constructing portfolios with outstanding risk/reward profiles that do not assume a high degree of capital risk. Before making an investment, we analyze a company as if we were private investors looking to purchase the entire business. We invest in businesses with understandable operating models, straightforward financial statements, and a proven ability to generate free cash flow and allocate it intelligently. We also seek securities that, in our view, have unrecognized potential. We believe the growth and uses of free cash flow represent the best predictor of long-term shareholder return.
Our goal is to produce an efficient portfolio on a risk/return basis. We undertake detailed fundamental research on individual companies, diversify across attractive companies and economic sectors, limit individual holding sizes, and employ a strict sell discipline. If we have identified a good business at a good price, time is our ally as patient investors. As a result, we have relatively low portfolio turnover in most strategies. Epoch’s Investment Policy Group, representing the most experienced members of the investment team, provides a macro-level perspective that portfolio managers may use as a context when evaluating individual companies and sectors.
Each company is analyzed as if we were private investors looking to buy the entire entity. The analysts evaluate the quality of management, the business model, financial statements, the operating environment and valuation. Key components of the process are outlined below.
- Evaluate Management – Seek management teams with a reputation for integrity and the ability and incentives to create shareholder value. In particular, we look for managements with a disciplined capital allocation policy as well as a demonstrated ability to deploy free cash flow for the benefit of shareholders. Frequent contact with company management helps us understand their perspective, verify information and monitor the underlying thesis.
- Analyze the Business – Evaluate the business model, unique assets and intellectual property in the context of industry trends and understand the sustainability of the business and barriers to entry. We estimate the impact of changes such as new management, the disposal of non-core assets, the launch of new products or entry into a new market. We are also mindful of regulatory and political issues.
- Understand the Cash-Flow Structure – Focus on companies generating cash earnings and assess the quality and character of these earnings. We stress “cash earnings” rather than GAAP earnings, as cash earnings better represent the operating and financial leverage that exists if one wanted to buy the entire company. We tend to avoid companies with a high degree of financial leverage.
- Determine the Enterprise Value – Apply market prices to the right hand side of the balance sheet. After summing those numbers, we remove any excess working capital from this total to arrive at the net value of the entity. We add that number to the capitalized value of off-balance-sheet liabilities to determine the firm’s enterprise value.
- Relate Cash Flow to Enterprise Value: – After determining the gross cash flows, deduct a "maintenance capex" number that leaves the firm in a "steady-state" position. This is the net cash flow from the business. Claims on net cash flow are examined to determine if they are necessary to maintain and grow the business. After deducting the relevant claims, the remaining total is the "free cash flow" available to shareholders. We rate the attractiveness of using it for dividends, stock repurchases, debt payment, acquisitions, or reinvestment opportunities within the firm. We then place a valuation on the free-cash-flow stream and compare it to the enterprise value to determine the firm’s attractiveness as an investment.
- Seek Unrecognized Assets – Identify hidden, undervalued or underutilized assets. This is of particular interest in small- and mid-cap companies where many are under-researched by traditional sell side-analysts.
- Risk Management – Risk management is integrated throughout the process with a focus on avoiding unintended risks. Portfolio risk exposures are monitored and formally communicated to portfolio managers on a regular basis and are discussed at investment meetings. A senior member of the Quantitative Research and Risk Management team is a co-portfolio manager on every strategy managed by Epoch.