BWFA Investment FrameworkMonday, September 30th, 2013
At BWFA, our overall investing approach is centered on identifying stocks that can be part of diversified portfolios that are appropriate for the models we have developed to invest clients’ assets. While we tend to favor industries with above-average growth rates, proper diversification requires that we hold companies in mature industries as well. We are not momentum investors, and we do not seek short-term trades.
One of the key ingredients in investment success is consistency in approach. Investors who constantly change style or pursue the latest market fad may realize occasional success, but over the long term they are likely to generate returns well short of market averages. At BWFA, we hope to find stocks that we can hold for three to five years, on average, that we believe have the potential to generate total annual returns of at least 15%. We recognize that it is unrealistic to think we will always be successful in identifying undervalued stocks, so we set our target higher than the overall return we expect to generate.
When we decide to purchase a stock, we also follow what we call an “investment thesis.” Our thesis lays out the investment case and helps guide the evaluation of our investments on an ongoing basis. Revisiting the investment thesis can help us better understand why we may have made good or bad decisions.
Underlying that thesis is our understanding of key criteria about the company, such as fair value estimate, earnings, cash flow, dividend, corporate leadership, and strategic vision. How we use those criteria in our screening process is discussed below.
Our Screening Process
Our stock-screening process has many steps. First and foremost, we seek to own companies selling below our fair value estimate. In general, we endeavor to invest in companies that are earning—and can be expected to continue to earn—above-average margins compared to peers. Such companies should have solid balance sheets (including low debt levels) and generate strong cash flow.
We also perform some accounting forensics to better assess the quality of earnings and cash flow. This helps us to determine if the company’s reported financial information appears reasonable.
In addition, we review documents filed with the SEC, company presentations, conference calls, and reports from analytical services. We research stocks that we are considering for clients’ portfolios, and we continually update our research for as long as we own shares.
If a company pays a dividend, we want to assess if it is sustainable and if it can grow over time. Especially when we are evaluating more mature companies, we prefer those that generate more cash flow from operations than is needed to meet ongoing business needs. The excess of operating cash flow can be either reinvested in future growth opportunities or returned to shareholders via dividends or share repurchases. We typically prefer dividends to repurchases.
It is rare to find a successful company without a strong leadership team. However, assessing management strength is one of the more nebulous aspects of investing. As financial advisors, it is important that we be good stewards of client capital. We look to apply this same philosophy to our investments by selecting companies that we believe are good stewards of shareholder capital. To help determine this, we try to answer questions such as, does the company’s return on investment exceed its estimated cost of capital, or does management consider the value of the company’s stock when it decides to repurchase shares.
We also want to see that the company has a strategy that is consistently applied, rather than one that is constantly changing, as the latter is emblematic of favoring the long- over the short-term. Corporate governance is also important, including an understanding of factors such as executive compensation and the independence of the board. We also attempt to answer some of the following questions: Does the company engage in financial engineering-type transactions to boost earnings? Is the company sometimes willing to endure some short-term pain in exchange for long-term benefits? Does management pursue growth for the sake of growth, or does it focus on profitable growth opportunities?
Selecting the Right Investments
A company can meet all of the above criteria and still not be a good investment. Valuation is a key facet of our investment approach. We are looking for companies trading at a discount to our long-term valuation assessment. We use a variety of metrics to make this determination. We look at relative valuation measures such as price-to-earnings, price-to-sales, price-to-cash flow, price-to-free cash flow, and earnings before interest and taxes to both enterprise value and capital. Where possible, we may also value a company based on our expectations of future cash flows discounted at the appropriate rate.
At the same time, we will typically avoid some companies. We will typically keep away from companies that are not generating current earnings or are not producing positive cash flow. There may be some exceptions, but only where we believe the company is pursuing a clear path to sustainable, long-term growth.
Of course, there are also times that even the best companies should be sold. Deciding when to sell a stock can be one of the most challenging parts of investing. As a result, it is important to have selling criteria. Reasons that could lead us to sell a stock include the following: (1) The shares appear overvalued or are trading near fair value, with no clear catalyst to push the price higher; (2) The business fundamentals have broken down; (3) Management has made missteps or changed strategy; (4) The original thesis for buying the shares no longer applies; and (5) Accounting-related concerns.
If you would like to learn how these criteria are reflected in specific investments in your portfolio, please contact a member of our investing team.