Before investing in stocks, it’s worth formulating a plan and constructing a process that guarantees discipline. This is how we do it in the Global Equities team.
In this series of blog posts, we dive into the strategy and daily life of Evli’s Global Equities team. The Global Equities team invests in underpriced companies that generate cash flow and have strong debt coverage.
Humans are not wired for investing. In the absence of formalized plans, they often ramble from fund to fund or stock to stock, captivated by catchy stories, anecdotal evidence and recent success, thereby invoking costs from overtrading and losses from unfortunate timing.
On the other hand, people with a well-defined investment strategy appear more consistent in their investment choices and performance. The conclusion must be that before investing in stocks, it’s worth formulating a sound plan and then constructing a process that guarantees discipline.
This is how we do it in Evli’s Global Equities team.
Valuation equation applies to stocks, too
The plan we follow rests on concepts such as the basic valuation equation, margins of safety, and financial statement analysis. We aim to add value over the cycle through bottom-up stock selection within a specific segment of the market: established companies that generate cash flow and have strong debt coverage.
The basic valuation equation has been around for centuries, in one form or another, and has survived a plethora of events and ideological paradigm shifts. It states that value equals expected discounted payoff.
Simply put, one should always ask how much cash a company will generate, when this is likely to happen, how uncertain that cash flow is, and what is the cost today (price) of participating in those future cash flows. The lower the price paid today for a given future cash stream, the higher the implied internal rate of return.
This is a universal and timeless concept, applicable to all assets, everywhere and anytime. For many, the equation comes naturally in bond investing but seems less obvious in stocks. Granted, it is more difficult to apply in stocks compared to bonds.
Cash flow analysis requires understanding of accounting and independent thinking
Portfolio management requires decision making under uncertainty. You need to make assumptions about things no one can forecast.
This is why using margins of safety makes financial sense. In valuation, it translates into recognizing that future cash flows can be delayed or less than we’ve become accustomed to, and that downside risks exist.
To understand a company’s cash flow, it’s good to have an understanding of accounting and the tenacity to read footnotes. You need to be aware of audit concerns, reporting and recognition principles, restatements, special charges, consolidation practices, and so on.
Our analysis is based on independent thinking, not imitation. This makes our portfolios different from the mainstream. It goes without saying that in active investing, getting a different result than other funds or market averages requires a different portfolio.
No benefits without discipline
Just like a diet or sports training program, investing produces few benefits without discipline.
In many cases, it’s unsafe to solely rely on self-control. That’s why you need a process that instills discipline on behavior. We apply strict criteria to separate the wheat from the chaff and have portfolio managers able to stare at the ticker tape for days without submitting to an urge to trade.
But of course, staring at high-frequency price quotes is a waste of time anyway, so instead, we stare at annual reports. The team approach also protects us from the slow mental drift that a loner may unconsciously fall victim to. While it may sound like something out of Orwell’s “1984”, we monitor each other’s actions and thoughts because that too helps us to guard against strategy drift.
While markets are subject to much noise and fluctuation, by virtue of strategy and process, our behavior never waxes nor wanes.