Identify undervalued companies that can attain their perceived intrinsic value over an acceptable investment time horizon
Businesses can trade at significant discounts when:
- Investors have concerns over future prospects or near-term earnings
- Companies possess a misunderstood asset base or complex business model
- Company specific strengths are ignored due to uncertain industry outlook
- Differences arise in analytical perspective (time horizon)
- Companies undergo a fundamental turnaround
Our efforts to identify these companies takes several forms: criteria based financial screening, referrals from our broad industry contacts, and our own in-depth knowledge developed over more than 20 years of investing in public companies. PCM’s screening process and broader investment approach is not limited by the market capitalization of a company.
In identifying opportunities, the investment team also leverages our extensive domain expertise in diverse market segments such as technology, financial services, consumer discretionary, healthcare, natural resources, and communications.
Quantitative Business Assessment
Once a potential investment opportunity is identified, PCM conducts exhaustive independent financial analysis focused on valuing a company’s business operations and assets over an identifiable investment horizon.
Included in this analysis is a focus on conducting financial statement adjustments to better reflect a fair valuation of the company’s assets, liabilities, and to identify any potential “footnote” risks such as underfunded pensions, off-balance sheet liabilities, aggressive accounting policies, etc.
In our experience, free cash flow is a superior measure for long-term investors.
A characteristic of a superior business is its ability to generate sustainable and growing free cash flow, which we define as cash flow from operations after required capital expenditures.
We value businesses by taking the net present value (NPV) of their free cash flow potential, discounted by a rate commensurate with the perceived business risk.
Free cash flow affords management teams with myriad ways to enhance long-term shareholder value:
- Capital efficient investments in internal operations, product development or expansion efforts
- Share repurchases
- Acquisitions
- Cash dividend payments
During turbulent periods where credit availability is unpredictable, businesses with consistent cash generation and the appropriate capital structure can control their own destiny.
Qualitative Management and Business Assessment
While comprehensive independent financial statement analysis is an integral part of our approach, a thorough review cannot be completed without making judgments on our “prospective” partners – the company’s management team and business.
Our qualitative review includes an evaluation of management’s:
- Compensation practices and goal congruency with shareholders
- Candor with PCM and willingness to treat shareholders as owners
- History of creating (or failing to create) value for shareholders
- Intellect, ability, innovation and focus
In the course of this analysis, we may seek input from, among others, competitors, suppliers, customers and other significant industry participants. The objective of this assessment is to ensure that in addition to being statistically attractive, management has the vision, competence and incentive to create value for shareholders.
Other items we look for:
- Ownership by management and the company’s Board of Directors
- Management and Board trading activity in the shares
- Quality and objectivity (independence) of the company’s Board of Directors
- Entrenched market position or sustainable competitive advantages
- Ability to compete effectively and succeed under various industry and broader economic scenarios
Where PCM identifies shortcomings or potential risks in these or other aspects of the company, it will seek to analyze and account for them relative to the overall attractiveness of the opportunity, understanding that risk or uncertainty in one or more of these areas may underpin or contribute to a compelling valuation.
Time Horizon & Investor Expectations
Initially, when we purchase a security we expect to realize fair value in the market over a multi-year time horizon, often 3 to 5 years. However, actual holding periods may vary based on market and company specific factors.
Stocks most often become available at our target discount because they are out of favor, misunderstood or disdained
- We have to be patient, as improvements can take time - our time horizon must match the opportunity
- We trust our research and investment thesis - even when contrary views may prevail in the short-term
- We are recursive and diligent in monitoring and evaluating progress
- We react as needed to facts that may challenge or change our investment thesis
Because investments are typically out of favor or in the midst of a business change (earnings volatility) when we are buyers, price movements can be unpredictable over the near term.
Portfolio Construction
While PCM’s stock selection process is built on bottom-up fundamental analysis, our portfolio construction process also incorporates a broader economic perspective. Our all capitalization approach allows us to pursue value wherever it is identified.
We typically initiate positions at weightings between 1% and 2% of portfolio assets. PCM normally maintains core position weightings of between 2% and 5%, though in certain instances positions may comprise as much as 10% of assets. The 10 largest holdings may frequently exceed 40% of account assets.
PCM does not seek to track a broader market index. Rather, we strive to allocate capital thoughtfully, and will frequently concentrate investments in areas where our research and world view identify significant opportunity.
Sell Discipline
Target valuations are established at the time of purchase and continually revisited to incorporate new information such as:
- Operational execution
- Company fundamentals and corresponding valuations
- Industry outlook and macroeconomic factors
PCM reduces exposure in holdings as they approach our estimate of intrinsic value or when warranted by either an adverse change in a material aspect of the business or its operating environment.