Intrinsic Value Opportunity

We are seeking stocks with the best long-term value attributes that have a reason to realize that value over the shorter term.

We begin constructing a 50 to 80 stock portfolio by reviewing data on S&P 500 Index companies to determine if a stock is attractive versus its Intrinsic Value. We start with a baseline intrinsic value from Ford Equity Research and select the stocks that are in the most attractive third of the index. Intrinsic Value is best described as the private market value of a stock, or the price that a buyer would pay for the company. We verify the inputs to the Intrinsic Value model, including the expected growth rate, normalized earnings and quality rating of the companies we select. The resources we use for this deep analysis on intrinsic value include corporate financial reports, Internet sites, quantitative evaluations, Wall Street research and government reports. This process allows us to have confidence that the names we are reviewing have the appropriate intrinsic value characteristics to raise their probability of outperforming the market.

We determine which of these approximately 170 stocks has the highest probability of outperforming the market in the next quarter by screening the group for companies with excellent market acceptance, financial strength or firm profitability. We perform parallel screens within the cheapest third of the S&P 500 for companies that have the best Relative Strength, Share Repurchase or Gross Profitability Return on Assets. To measure market acceptance, we review a stock’s relative strength. We have found that relative strength combined with attractive intrinsic value usually indicates the market recognizes a stock is undervalued. Historically, it has lead to outperformance in the future. To measure financial strength, we screen for companies that are among the best ranked by share repurchase. This indicates a company is financially strong enough and desires to retire shares from the market. It has been an excellent indicator of future stock price performance, and also has good characteristics when combined with intrinsic value. To measure firm profitability, we rank the index by Gross Profitability Return on Assets. This measure eliminates much of the “noise” that can arise from the difference between gross profits and net profits and has been an excellent indicator of future stock price performance. We have found it combines well with price to intrinsic value. Our goal is to screen for the cheapest third of the universe for stocks that are in the best rankings within the index based on one of these measures.

We review business risk when we scrub the names at the beginning of the quarter. In this step we evaluate the consistency of a company’s earnings, debt coverage, and market cap to determine the quality of the company. This is how we evaluate the staying power a company has. Companies with more business risk and less staying power carry a higher discount rate than those with higher quality characteristics. Between quarterly rebalancing, we only evaluate business risk if a stock goes on the watch list.

We run these models quarterly, and after scrubbing we generally remove 10% to 15% of the stocks that pass the initial screens. Following that, we equal weight the stocks that result from the process.

Our universe for this strategy is US domestic large cap stocks in the S&P 500 Index. Since we view this as a value oriented strategy, we compare the individual security results to the Russell 1000 Value Index. We select from the S&P 500 Index for several reasons. First, it provides us with a large cap, highly recognized and easily tradeable universe. More importantly, we believe value can exist in all industries, not simply those that measure well on traditional value factors. Using the S&P 500 Index allows us to invest in valuable companies wherever they reside in the economy.

The first screen is to segregate the stocks in the best third of the S&P 500 Index as measured by intrinsic value. Following this, that list of approximately 170 stocks is further narrowed to include only those that are in the best ranks of Relative Strength, or Share Repurchase or Gross Profitability Return on Assets. We have found that narrowing the list of stocks to include positive market acceptance or financial strength or profitability improves the returns of the strategy.

When this narrower list is prepared, usually between 50 and 80 names remain. These names are then “scrubbed” by the portfolio management team. “Scrubbing” is the process where the portfolio managers debate the inputs into the Intrinsic Value model, and determine if the stocks truly represent value. Stocks that survive the scrubbing process are included in the portfolio for the upcoming quarter in equal weights.

We implement risk controls to limit the damage that any individual stock can do to the portfolio between rebalancing periods. We monitor performance, and if any stock in the portfolio underperforms the Russell 1000 Value Index by 10% in a quarter, it can be removed from the portfolio at the discretion of the management team. If a stock underperforms the Russell 1000 Value by more than 20%, it is removed from the portfolio automatically.

This strategy is based on buying a selection of S&P 500 Index stocks. As such, we can buy the largest cap or smallest cap stocks in that index. It is unconstrained in sector selection. We apply the process noted above and rebalance the portfolio on a quarterly basis.

We limit our purchases to S&P 500 Index stocks. With a goal of 50 to 80 names and an equal weighted portfolio, our initial positions are generally in a range of approximately 1.25% to 2.0% per security. Following that, we do not limit the upside potential for a stock, but we do limit the downside to 20% underperformance relative to the Russell 1000 Value Index. As such, our downside limit position would generally be around a minimum holding of 1.0% (1.25% x 80%).

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 trails the Russell 1000 Value Index by 10% or more during a quarter. The portfolio management team reviews stocks that violate this level for sale and will sell them if we believe the intrinsic value has been impaired or if the fundamentals for a company have changed. A stock is a mandatory sale when it trails the Russell 1000 Value Index by 20%. The object of the selling disciplines is to take any emotion or manager bias out of the process if a stock hits the 20% stop-loss.

Performance Disclosure Opportunity
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Opportunity Annual Disclosure Presentation 2011
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