All of 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 on a continual basis.
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 a vis these themes/trends drive our asset allocation decision relating to appropriate client portfolio asset mix 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 as well as those that tend to have 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? In other words, what is the “intrinsic value” of the company? 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 – Often this is a good company that has hit 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 compared 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 intention is to remain invested in a company for the long-term, our sell proposition is driven by the following considerations:
- “overvalue” - stock price has exceed 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 over-paid 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, both a positive and negative manner, investors tend to overreact to major, but unlikely events. Too much emphasis is placed on outcomes. (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
Essentially, there are four ways in which value is realized in the capital markets. The most common method is simple “regression to the mean”. Everything concerning markets and economics regresses from extremes towards the norm and usually faster than investors realize. Over time the perception of an undervalued stock will change from negative to positive. The second way is though a corporate takeover (the undervalued company is purchased at a premium by another company). The third way is though 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.