Written By: David Herro
Applying strong discipline to every stage of the stock selection process is key to a successful investment. David Herro of Harris Associates explains more
Some equity risk reduction strategies have existed for as long as the asset management industry. Fundamental investing falls into this category. It may not explicitly seek to reduce risk, but when strong discipline is applied to the fundamental investment process, the risk/return profile can be significantly raised over the longer term. Harris Associates has employed the same investment process since 1976 and, partly due to its roots in managing family wealth, it defines risk as the permanent loss of capital, rather than performance versus an underlying benchmark.
Purchasing businesses at a discount to intrinsic value can be inherently risk-reducing. We at Harris invest in a stock only if it meets its stringent valuation criteria: 70 cents on the dollar or cheaper compared to its evaluation of a company’s intrinsic value. Stocks that are fully valued by Harris’s criteria are not considered in portfolios even if other investors view them as “safe” or “defensive”. For this reason, we do not currently favour utility stocks or the high dividend yield stocks beloved by many managers. Risk is highly dependent on the price you pay for a stock. In the 1990s, people were buying tech stocks at the top of the market and some investors may have made the same mistake by buying so-called safe stocks or high income stocks in the current market. We see risk as the chance of losing shareholders’ capital by paying a high price relative to intrinsic value.
Another key risk to address when choosing stocks is company management. We look for high-quality companies that have strong franchises and free cashflows. Furthermore, we look for management teams that have the skill and experience to allocate free cashflow efficiently. In other words, management teams must have a track record of creating value in all market environments.
Intensive research is required in a bottom-up stock selection process. Our analysts operate as generalists rather than assigned to sectors. This freedom allows them to compare companies among different industries to find the most attractive opportunities across the market and avoid the risk of picking a stock that is only attractive on a relative basis within a specific sector.
Whereas the stock selection process at many investment firms ends at the investment committee stage, we perform one further risk management exercise. Throughout the year, the investment team’s analysts volunteer to be “Devil’s Advocates” – to challenge the views on every new stock idea and on the firm’s existing top holdings. They question the assumptions that are used to determine the intrinsic value of a business such as a company’s sales growth projections, future margins and terminal-year multiples. Every aspect of the original stock selection decision is tested – the ultimate goal being to avoid “group-think”, thereby addressing a risk which many investors tend not to consider.
Disclaimer: This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced, are as of 30th August, 2013 and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material. This material may not be distributed, published, or reproduced, in whole or in part. Although Natixis Global Asset Management believes the information provided in this material to be reliable, it does not guarantee the accuracy, adequacy or completeness of such information.
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