HCM’s investment process is driven by in-depth, internal, 100% bottom-up fundamental research. Our Los Angeles (El Segundo)-based investment staff is organized by industry coverage rather than market cap range and, consequently, all individuals support all of the firm’s strategies.
Individual security analysis is the principle driver of the portfolio construction and decision-making process. Of primary importance to the security selection process is the determination of “normalized” earnings for each company under review. A company’s “normalized earnings power” is the sustainable cash earnings level of the company under equilibrium economic and competitive market conditions. In the most general sense, normalized earnings are calculated by adjusting a company’s reported earnings to account for the impact of the economic cycle, an appropriate level of financial leverage, suitable capital allocation assumptions and non-operating accounting items such as pension accounting. This calculation of a company’s sustainable earnings further includes modifying the impact of mean reversion adjusted returns on equity invested, including normalized profit margins. In the course of our analysis, debt ratios are scrutinized to assess a company’s balance sheet strength during the reversion period; while a thorough review of maturities and free cash flow allows us to assess liquidity.
At HCM, we believe there are two means to add alpha to a portfolio, 1) avoid securities that underperform the market (“value traps”), and 2) invest in securities that outperform the market (“value opportunities”).
During the initial review we seek to differentiate value traps from value opportunities, thereby identifying securities that will underperform the market in either the short- or long-run. At HCM, we have identified two types of value traps, both of which we attempt to avoid as long as there is the potential for negative alpha generation.
The first type of value trap is long-term in nature and is generally associated with stocks we believe will perpetually underperform. Analysts attempt to identify these stocks during the initial review using a proprietary reconciliation tool that identifies companies whose cash flows may not support earnings growth expectations. These companies tend to be perpetual underperformers as they continually disappoint investors (thus the term long-term value trap) and are therefore not attractive investment opportunities.
Short-term value traps, on the other hand, are stocks that are attractive investment candidates from a valuation perspective but for which there is the likelihood that non-fundamental news exists which could negatively impact the future stock price. Taking a position in a short-term value trap too early, in other words, before the negative news is understood by the market and fully incorporated into the stock price, often results in negative alpha generation. Our goal with these stocks is for the negative news to be incorporated into the company’s stock price prior to establishing a position. Short-term value traps are identified using another of HCM’s proprietary tools, the “Red Flags” checklist.
The last step of the initial review is a preliminary industry analysis which provides an initial assessment of the industry’s competitive dynamics. In general, the initial review process is used to put forth an initial assessment of valuation and determine whether or not further research is warranted.
Upon passing the initial review, investment candidates are subjected to rigorous fundamental analysis. This phase of the research process involves forecasting a company’s financial statements, not only at the aggregate level, but also for each business segment, an exercise that is particularly important when businesses within a company differ materially in terms of operating characteristics and/or variability of earnings. Once we believe we have arrived at our best estimate for normalized earnings for each business within the company, we can then roll-up the individual business segment data to the total company level, providing for, in our view, a more accurate forecast than analyses which rely on aggregate data alone.
Portfolio construction is the direct result of HCM’s bottom-up investment process where the weight of each holding is determined based on its risk/reward profile relative to all other investment opportunities. Factor analysis is employed as part of this process to help ensure our portfolios are properly diversified and make no implicit or explicit macroeconomic bets. These processes, which are disciplined, unbiased and repeatable, result in a diversified concentrated portfolio with, we believe, the potential for meaningful alpha generation accompanied by tangible valuation support.