Large Cap Intrinsic Value

We begin constructing a 40 to 60 stock portfolio by reviewing a universe of approximately 4,500 names from sources such as Ford Equity Research, corporate financial reports, Wall Street research, Internet sites, quantitative evaluations, and government reports to determine whether a fundamental prospect is favorably influencing a company, looking for companies with a minimum market capitalization of $1 billion and a quality rating of B- or higher.

The research results in specific investment decisions that lead to the formation of an investment model that the portfolio managers must use in all our fully discretionary tax-exempt portfolios. While holdings in the portfolio are reviewed formally each week, informal discussions take place daily and changes are made whenever deemed appropriate. The experience of our professionals serves to tell us when certain market factors and research carry more or less importance over time.

Our portfolios typically hold 40-60 stocks. Most of the stocks are assigned a weighting of 1-3%. Occasionally, a stock is given a higher weighting if we have a great deal of conviction about its near term outlook. Stocks with a stronger track record and ones we have used successfully before may also warrant a larger weighting while new names may start out at 1%. The largest holding may be 3% at cost and 5% at market (unless the client determines otherwise).

The final step in the creation of a portfolio is the application of our sector guidelines. The S&P 500 serves as the foundation for our sector decisions. All major sectors of the S&P 500 are represented. We may choose not to participate in sectors with weightings less than 3%. Our LCIV sector weightings may not exceed the comparable S&P 500 sector weightings by ±6% absolute or ±50% relative, whichever is greater.

Risk management plays a significant role in the portfolio construction process. Stocks are purchased at attractive prices, therefore, less risky. Our portfolio is broadly diversified (40-60 stocks) with large cap holdings with a minimum quality rating of B-. The maximum weightings at purchase are 3% at cost and 5% at market value. We have sector allocation rules which allow us moderate deviation from the S&P 500 benchmark. This protects against significant sector shortfalls and allows stock selection to drive alpha.

Additionally, our sell discipline is a risk control measure. We constantly monitor a stock’s intrinsic value. Stocks with high intrinsic value tend to be more volatile and underperform the market in subsequent periods. Our multi-factor ranking will fundamentally bear out any holdings that are weakening. These holdings are removed from the portfolio a high percentage of the time.

Approximately 65% of the portfolio’s risk is controlled through the diversification and sector decision rules. Another 35% is controlled by the price/intrinsic value factor.

We begin constructing a 40 to 60 stock portfolio by reviewing a universe of approximately 4,500 names from sources such as Ford Equity Research, corporate financial reports, Wall Street research, Internet sites, quantitative evaluations, and government reports to determine whether a fundamental prospect is favorably influencing a company, looking for companies with a minimum market capitalization of $1 billion and a quality rating of B- or higher.

We determine which of these stocks has the highest probability of outperforming the market in the future by blending elements of valuation, fundamental strength (i.e. strong and rising earnings), and technical strength into our proprietary multi-factor ranking model. The multi-factor model specifically looks for stocks that have attractive P/IV and price to earnings ratios. It also favors stocks with positive earnings revisions and earnings momentum. These fundamental measures tend to lead stock prices. The final factors measure the technical strength of a stock.

A mathematical model is then applied to identify the most undervalued companies (those with the lowest P/IV ratio), which we believe have the greatest potential for price appreciation. However, because undervalued stocks can stay undervalued for extended periods of time, we implement fundamental research and market recognition components into our process. We apply fundamental analysis to the remaining 250 stocks to determine which ones contain a fundamental prospect for growth that would cause an increase in the stock’s valuation. The fundamental prospects include positive earnings momentum, corporate restructuring, favorable legislation, stock repurchase, or spot news. These fundamental prospects all have in common the early identification of a sustainable improvement or acceleration in earnings. We then measure the relative strength and accumulation/distribution activity of the stock. These factors will tell us if the marketplace is confirming or rejecting our thesis. This confirmation will help us avoid value traps.

There are two different levels of urgency for selling that can best be described as either discretionary or mandatory. A stock is considered for sale when its price trades at a 30% premium to the S&P 500 or the fundamentals of a company or an industry are perceived to have weakened. A stock is a mandatory sale when its price trades at a 50% premium to the S&P 500. A second mandatory sale occurs when a structural negative appears. Finally, if we become concerned about the integrity of a company’s accounting, the stock is sold immediately.

Performance Disclosure LCIV
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LC Intrinsic Value Annual Disclosure Presentation 2011
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