We generate alpha in two ways: through share selection and through portfolio construction. We follow a highly disciplined investment process to build diversified, risk-adjusted portfolios. Relentless research and rigorous debate underpin every step of our process and guards against emotional bias. The result is that we only invest in shares that we are convinced will outperform the market over the medium term.
- Step 1. Fundamental valuation
The foundation of our investment approach is identifying companies that are undervalued by the market. We do this by calculating the intrinsic value of each company in our universe based on our analysts’ forecast of future cash flows. As the nature of forecasting is subjective and it is impossible to predict the future, our analysts also calculate probability-weighted bull- and bear-case scenarios, in addition to our base-case valuation. Besides appreciating a more optimistic scenario, this also highlights the downside or potential capital loss of each share. A margin of safety is then applied, which reflects the levels of:
i. uncertainty in forecasting a company’s cash flows
ii. management stewardship, and
iii. competitive advantage for every company with a narrow or wide economic moat rating.
We then seek further confirmation and insight from other proven attributes that we have studied on the JSE. These are:
QUALITY. We focus on cash flows rather than profits, using cash flow return on investment (CFROI) to determine a company’s true potential to generate shareholder returns over time. We also analyse the historical volatility of the share price under different market conditions. High quality companies tend to outperform the market with less risk.
- GROWTH. We seek companies offering the potential to grow earnings faster than the market average over the next two years. We also analyse company and industry data for directional trends in earnings revisions. Companies delivering stronger earnings growth than the market tend to outperform with less risk.
- SENTIMENT. We analyse the short- and longer-term market sentiment indicators to give us a sense of the market’s “mood”. An undervalued quality company, supported by positive share price sentiment, supports our conviction. Conversely, a company with poor share price sentiment is a focus for further research, as it is viewed as a potential opportunity to invest in an “unloved” share.
Including these attributes in our final evaluation of a share gives us a more balanced perspective and helps moderate the negative impact of market cycles.
- Step 2. Ranking each share
Ranking the shares provides an objective framework for further analysing the attractiveness of companies: A score is allocated to each measurement factor, with a majority weighting to valuation. Shares with the highest overall score typically represent “buys” and shares with lower scores represent “sells”. This is a dynamic process with rankings changing as and when new information becomes available.
- Step 3. Creating a model portfolio
The next step is to build a portfolio using our in-house developed portfolio modeller. The modeller takes into account both the scores of each share and a range of risk considerations. These include the impacts of potential macro-economic risks, contributions of shares and sectors to portfolio volatility, optimal diversification, tracking error and overall portfolio volatility. The final result is an optimal and a risk-adjusted portfolio that forms the basis for debate and further analysis.
- Step 4. Robust debate
We now stress-test our model portfolio. Assumptions are challenged, outcomes scrutinised and share selection validated or refuted. To better understand both upside and downside risks, we look at the probabilities of bull- and bear-case valuations for each share. We also pay particular attention to understanding the potential capital loss and to what is implied in the market price of a share. The graphic shows how shares ranking highly on their fundamental value as well as the confirming themes represent a strong-conviction “buy”. Conversely, shares ranking poorly on all four metrics are given a “sell” or an “avoid” status. Shares ranking highly on one measure but not on the other generally results in further analysis and debate to either gain conviction or confirm our misgivings.
- Step 5. Informed portfolio selection decisions
This rigorous analysis provides clear insight, informs debate and allows us to make portfolio allocation decisions with conviction. The portfolio managers, being fully accountable for the final portfolio, decide on the final sector weights and equity selection.