Investment Philosophy/Process

Philosophy

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Clients have absolute liabilities, whether they be pension liabilities or targeted distribution levels.  These liabilities do not fluctuate with the returns of the financial markets. Many solutions designed to satisfy these absolute liabilities are relative return products.  At Vaughan Nelson we construct portfolios with an objective of a targeted return.  Our equity products seek to compound client capital at 15% annually.  We target this return by investing in companies that we believe can achieve a 50% return over a three year holding period, or 15% compounded annually.  This targeted return approach leads us to seek any names that can generate our return objective, as long as they are within the market cap range of the relevant benchmark at the time of purchase. A company’s representation within an index is not a deciding factor on its inclusion in the portfolio.  Consequently, all of Vaughan Nelson’s equity portfolios exhibit a very high active share.

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Investment Process

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While we implement a fundamental, bottom up process, we believe it is important to have a construct of the macro environment.  We know that we cannot precisely predict interest rates, commodity prices, geopolitical events, or a host of other macroeconomic factors.  However, we can consciously, deliberately and dynamically evaluate these factors for extremes.  In so doing we can take advantage of what ht market is ‘giving’ us.

When seeking names for our portfolios, we target companies that fall into one of three categories (referred to as A, B or C). Each category represents a distinct avenue by which an investor can earn a return.  We seek a 50% return from every position, regardless of category.  The ability to rotate among these categories provides an ‘all weather’ aspect to our portfolios.  This allows us to take advantage of market opportunities rather than reverting to the mean through time as a process moves in and out of favor.

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Category A: Positive Economic Margin

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In this category we are seeking companies that are earning at or above their cost of capital.  Such returns on capital must be table-to-improving and the valuation must be at a level where we can earn 50% over a three year holding period.  These are generally high returns businesses where, for what can be a myriad of reasons, the market under appreciates the future earnings potential of the company.

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Category B: Undervalued assets with a catalyst

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Category B stocks are companies that are economically viable; however, they are priced at a steep discount to their asset value.  The stock can’t simply be cheap.  We have to see an identifiable, high-probability catalyst that will result in an upward revaluation of the company.

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Category C: High dividend yield
 

With category C stocks we are seeking to earn the preponderance of our targeted return through the dividend yield.  Such opportunities tend to be a small portion of the portfolio.   However, there are times when a company with an attractive yield falls out of favor.  If the company is economically viable and we have high conviction that the dividend is safe, we may consider the company as a candidate for the portfolio.

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Valuation and Risk Controls

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The majority of the companies we evaluate will be run through a three-stage discounted cash flow analysis (DCF).  The inputs to the DCF will be based upon our analysis of a company’s financial statements over the past seven years.  We then model every line item on the income statement and balance sheet for the next five years.  In this process we adjust the inpusts as we see fit to appropriately recognize and account for what we believe to be the economic realities if the business.  Companies that are not earning their cost of capital could be ‘serial diliters’ via acquisitions or over investing in their business.  A hallmark of our investing is to be in stocks where there is an asymmetric return outcome.  That is, there is limited downside and significant upside potential.

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Vaughan Nelson’s Risk Officer monitors the portfolios to ensure that actual exposures coincide with our intended exposures. A combination of vendor-provided risk analysis software, proprietary portfolio monitoring tools, and daily market data provide not only a view of our portfolios' exposure, but also insights into how the exposures affect performance and if market activity is conducive to our investment view(s). The Risk Officer monitors the portfolios and communicates findings to the investment team. The investment team then decides if any action is warranted.



 

Sell Discipline



We believe a sound sell discipline is critical both for capturing returns and controlling risk. We will sell out a position for the following reasons:



• Our price target is reached. Hacing a target price reduces the emotional impact on investing. We don't want to be "married" to our winners.
• Our investment thesis breaks down. We are paid to invest in what we know and what we can analyze, not what we hope might happen. Our investment thesis further reduces the potential for emotions to outweigh reason. If the reasons we bought a stock no longer hold true, the position is sold.
• We find a better idea. Sometimes a good idea has to make way for a better idea. This focuses your investment dollars on our very best ideas.