Investment Process
Step 1: Macro View
Our macro view plays a very important role in our investment process. We believe the financial landscape has changed, that market volatility will remain higher than normal for the next 4-5 years, and equity markets will continue to be challenging. We manage strategies that we believe can capitalize on this changing economic climate.
Many of the forces that drove the bull market of the 1980s-1990s have begun to unwind and will create headwinds over the next decade:
- Interest rates, which have decreased ever since the early 1980s, are at record lows and are poised to increase once the stimulus takes full effect
- Tax rates, which decreased significantly during the 1980s-1990s, are expected to increase
- Credit, which became easier and easier to abtain over the past three decades, has already tightened as a result of the 2008 crunch
- A powerful shift in demographics is about to take place. The baby boomer wave, which from trough to crest represents the largest generational wave we´ve seen in centuries, has begun its decline as boomers have started to retire. This associated shift from consumption to saving is likely to have a significant impact on economic growth
Slower GDP growth and a behavioral shift by U.S. consumers (to higher savings rates) are likely to result in mid-single digit equity returns for many years. As a result, we expect income from dividends to be a larger portion of the total return in the equity markets.
Step 2: Focusing on Income & Protection
Given the current market environment, we believe investors should focus on income-oriented strategies that provide enhanced yield and downside protection. We have managed an enhanced income (covered call) strategy since 2002 that is well suited for today´s uncertain markets. Unlike most equity strategies, which rely on price appreciation for most of their return, our covered call strategy seeks to "lock in" a significant return from the beginning by emphasizing income (dividends and call premiums) over growth. The result is a larger percentage of current year cash flow, which provides additional yield and downside protection. Our dual objective in this strategy is to produce high income (typically over 8%) as well as additional upside potential of 15-20%.
This strategy focuses on two specific sources of income
- Dividends: We invest in high quality, dividend-paying companies with high ROIs, below average debt, and a consistent track record of creating value for shareholders. We believe dividends will continue to account for approximately 50% of total equity returns, as they have over the past 100 years.
- Option Premiums: We "cover" our portfolio by writing call options on our positions. The result is lower volatility and less dependence on bull markets to achieve positive returns. We view volatility and time as assets...allowing us to "get paid" while the markets decide which way to go. By writing covered calls, we are effectively trading a portion of the (uncertain) upside potential for (more certain) current period income.
Our-income focus results in a portfolio with:
Higher-than-average income (we typically target 8-10% of annual income)
25% of total upside potential (calls are typically 10-15% out-of-the-money)
Lower-than-average portfolio volatility (our standard deviation is 10.0% over the past 8 years versus 15.7% for the S&P 500)
Step 3: Stock Selection
Our process combines three unique sources of competitive advantage:
Fundamental Analysis
The HOLT™ framework plays and important role in our investment process. Its objective, fundamental valuation framework enables us to distill away accounting distortions and identify the companies that truly create wealth over time.
Technical Analysis
We use Fibonacci numerical sequence to set portfolio weightings, determine entry/exit points, and to optimize our option trading. This analysis helps us identify characteristics of price trends (distance and time) in order to improve risk/reward modeling.
Risk Management
We utilize tolerable risk models, Value-At-Risk models, options, and strict stop-loss procedures in order to manage portfolio risk. As a result, our portfolios tend to have significantly lower volatility compared to their benchmarks.
Step 4: Portfolio Construction
Risk management is central to everything we do. Even our portfolio construction is driven by our risk management process. While most managers equal weight their holdings based on dollars invested, we equal weight based on downside risk. The largest weighted positions in the portfolio are those with the best risk/reward holdings. Also, rather than using a blanket approach to option writing (e.g. writing all options 10% out-of-the-money), we use our target prices to determine our option strike prices. This allows growth holdings to appreciate more while steady holdings with limited upside are written closer to the money in order to maximize income.
|
|
