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2006-12-12 :: Philosophy and Practice (Entry #2)

Below you will find our internal operating document that outlines for the staff our Philosophy and Practice in the investment management business.  In today’s first post, I discussed our Earnings Growth Model.  This document will give you a better understanding of how it works and how we use it in our wider work of investment management.  Normally, this is something that I use to educate our staff on the BankChampaign way of managing money, but as I was reviewing it I thought you might also like to see it.

Please ignore some of the formatting issues in this post as I tried to cut/paste from the original Word document, and the formatting did not translate to the blog and I can’t seem to correct it.

Soon, you will be receiving a newsletter that details our view on 2007 and where we feel you will make the most money.

I hope all is well with you and yours this holiday season.

Happy Holidays!

Mark

BANKCHAMPAIGN INVESTMENT MANAGEMENT

PHILOSOPHY AND PRACTICE

PHILOSOPHY

At BankChampaign, we are committed to building and managing client investment portfolios that consistently and handily outperform their benchmarks.  We utilize a proprietary system that is grounded in proven investment fundamentals and incorporates our core investment management principals of Sector Allocation, Earnings Growth, Diversification, and Valuation in equity selection.  We will never manage a portfolio as if it is a proxy for an index fund.  We believe our clients pay us to utilize independent thought in order to provide superior returns at managed levels of risk.  We will make our investment management process as visible and understandable as possible for our clients so that they will always know what we are doing and how we are doing it.

 

 

PRACTICE

As we put our philosophy into practice, we apply it to portfolios of individually managed securities as well as managed portfolios of mutual funds. We establish a written and published Investment Strategy and provide periodic updates to it.  We manage client portfolios around mathematical targets and compare performance to widely followed benchmarks. 

 

Asset Allocation

Asset Allocation is the primary determinant of risk, return, and cash flow in an investment portfolio, and it is the first consideration in structuring a client’s portfolio.  Choosing the correct asset mix between equity, fixed income, and cash equivalent investments is always the firs decision, but it must be reviewed over time to ensure that it is relevant for a client’s then-current position in life and risk tolerance.  Our baseline asset allocation is 65% Equities and 35% Fixed Income securities as that allocation has been statistically proven to provide the highest potential return at the lowest standard deviation of returns (also known as risk).  Clients can be more or less aggressive than that depending upon their choice (a fully diversified portfolio, a best ideas portfolio, dividend income portfolio, or a single sector portfolio), their level of willingness to assume risk (increasing or decreasing the percentage allocation to equities and fixed income securities), or their cash flow requirements (dividend income, taxable or tax-exempt interest).

 

Equity Investments

  • Sector Allocation in equity portfolios accounts for a significant portion of a portfolio’s total return.  Based upon our financial analysis of long-term trends – financial, demographic, societal – we will overweight or underweight sectors in order to enhance portfolio returns and reduce overall risk.
  • There are three drivers of stock prices:  earnings growth, valuation, and investor sentiment.  The core of our equity holdings are selected from the individual companies as rated by our proprietary Earnings Growth model, which incorporates a number of factors
    • High Earnings Growth:  earnings growth is a primary driver of stock prices – emphasis is placed on upward earnings revisions and surprises and an earnings growth rate well above average
    • Consistent Profitability:  consistent profitability is a sign of well managed company – emphasis is placed on five years of pre-tax earnings growth consistency
    • Reasonable Valuation:  we ensure that a company is not overvalued compared to its earnings growth and liquidation value – emphasis placed on the PEG Ratio and the Cash Takeover Value of the company
    • Industry Leadership:  companies that are financial leaders in their industry provide a level of safety – emphasis is placed on ROE, Operating Margins, Yield, and Price to Sales
    • Investor Sentiment:  companies tend to go in and out of favor, and their stock prices reflect these swings – emphasis is placed on superior past price performance with increased emphasis on the most recent three months
  • The emotional swings of the stock market that drive stock prices to new highs and new lows not supported by fundamentals, over time, cancel each other out.  By focusing on earnings growth, we are able to provide better-than-peer and better than benchmark returns for clients.
  • We also select companies to include in client portfolios from certain special situations:  cash flow generators, turn around situations, and commodity stocks.  When purchasing companies in these situations, we try to incorporate as much analysis from our Earnings Growth model as possible.

 

Fixed Income Investments

  • Determining the need for tax-exempt income is the first step in our fixed income management process.
  • We then build the fixed income portfolio, selecting securities from among:
    • AAA Rated Insured Municipal Bonds, if tax-exempt income is appropriate
    • AAA Treasury and Government Agency Securities
    • Investment Grade Corporate Bonds
    • Fixed Income Equivalents, where appropriate – REIT’s, MLP’s, Royalty Trusts, and equities with high dividend payout ratios

 

Mutual Funds

Our managed mutual fund portfolios are designed to reflect our views of the financial markets as detailed in our published Investment Strategy.  They utilize no-load mutual funds, and our fee schedules are discounted from those of individually managed security portfolios to reflect that the funds themselves charge management fees.  We compare performance to blended indices to ensure that our mix of funds is performing as desired. 

 

The portfolios are designed to span the risk/reward continuum, and utilize a properly diversified mix of equity and fixed income funds. 

  • Equity funds incorporate both growth and value styles; large-, mid-, and small-cap; and domestic and foreign.
  • Fixed Income funds incorporate short-, intermediate-, and long-duration, domestic and foreign.

 

Portfolio Management

We manage portfolios around the following mathematical targets:

  • Asset Allocation:  we monitor a portfolios current asset allocation, making changes as needed to realign the portfolios to target asset allocation
  • Equity Investment Style: one consequence of our Earnings Growth model is that we tend to favor Growth companies over Value companies in client portfolios.  Our target for fully diversified portfolios is 75% Growth and 25% Value, with the value companies being selected from the special situations above.  For clients that choose a portfolio that is not fully diversified, this measure will not apply.
  • Equity Capitalization:  historically, small- and mid-cap stocks have outperformed large-cap stocks and provided much needed diversification.  Another consequence of our Earnings Growth model is that it tends to favor small- and mid-cap companies that have higher levels of earnings growth.  Our target for a fully diversified investment management portfolio is 50% Large-, 30% Mid-, and 20% Small-cap stocks.  For clients that choose a portfolio that is not fully diversified, this measure will not apply.  For traditional trusts, our target is 70% Large-, 20% Mid-, and 10% Small-cap stocks.
  • Equity Domestic/Foreign Allocation:  historically, foreign stocks have outperformed domestic stocks and provided much needed diversification.  Our target for a fully diversified portfolio is 75% Domestic and 25% Foreign.  For clients that choose a portfolio that is not fully diversified, this measure will not apply. 
  • Equity Earnings Growth:  Our target for the equity portion of a fully diversified portfolio is to have earnings growth average in excess of 15% for portfolio overall.  For clients that choose a portfolio that is not fully diversified, this measure will not apply. 
  • Relative Equity Earnings Growth:  Our target for the equity portion of a fully diversified portfolio is to have relative earnings growth average in excess of 125% of the S&P 500’s earnings growth for the portfolio overall.  For clients that choose a portfolio that is not fully diversified, this measure will not apply. 
  • Portfolio Valuation:  We utilize the PEG Ratio for the portfolio overall and compare it to the S&P 500’s average PEG Ratio.  Our target for the equity portion of a fully diversified portfolio is to have its PEG Ratio be no more than 90% of the S&P 500 PEG Ratio.
  • Equity Sector Targets:  Based upon our published Investment Strategy, we overweight or underweight equity sectors to enhance returns and manage risk.
  • Diversification:  In order to minimize the risk of loss from company-specific events, we maintain positions of no more than 4% of portfolio value in any one company

 

Purchase Strategies

We purchase investments with the expectation that they will be long-term holdings in client portfolios.  When we make a purchase, we determine if we want to purchase it at the current market price because it is a good buy at current levels, or alternatively we enter a Good-Till-Canceled purchase order at a price below current levels. 

 

We set a target price for the stock based upon estimated earnings and valuations, determine what our potential appreciation is, and in many cases set a stop loss to protect the portfolio from the impact of some unforeseen negative information on a new holding. 

 

During a volatile market or a highly appreciated market, we may look to build a position in a stock in client portfolios.  We may purchase a few small lots over time to protect against sudden downturns in the broader market or a correction in a market sector.

 

Sales Strategies

There are a number of reasons that we might sell a holding when we deem it to be appropriate:

  • The stock has achieved its price target and we do not see adequate additional appreciation potential to justify holding it
  • The company’s earnings growth has slowed
  • The company reports earnings below estimates
  • The company has balance sheet problems
  • The industry sector has fundamental problems
  • The stock has dropped below some major technical level
  • We were unable to build our position in a stock due to market movements
  • A stop loss triggers a sale

 

Risk Management

When we determine it to be useful, we utilize stop loss orders in order to protect portfolio positions, based upon the most appropriate of the following:

·        New Purchases:  a stop loss set at 8% below purchase price or set at 1/3 the potential appreciation below the purchase price, providing a 3-to-1 reward-to-risk ratio

  • Existing Holdings:  a stop loss set below an appropriate technical price level, a price that represents a 3-to-1 reward-to-risk level on a revised target price for a holding, or at an original target price can protect a gain in a holding from being erased when sentiment turns negative but fundamentals remain positive:
    • 13-, 22-, 50-, or 200-day Moving Average prices
    • Bollinger Band mid-point or lower-band
    • Fibonoci Retracement Levels of 23.6%, 38.2%, 50%, 61.8% and 78.6%
    • When revising a target price for a holding, we may set a stop loss at 1/3 the potential appreciation from the revised price below the current price, providing a 3-to-1 reward-to-risk ratio
    • Original Target Price stops may be used for stocks that have exceeded their original target prices but either
      • a new target price has not yet been established or
      • the stock has been designated as a candidate for sale but we believe there may continue to be some near-term upside potential price appreciation

 

Benchmarks

In evaluating our performance, we compare our returns to those of established indices, which are consistently applied each reporting period.

  • Wilshire 5000 – the most encompassing of equity benchmarks as it includes large and small cap stocks as well as foreign ADR’s
  • Merrill Lynch Corporate & Government Bond Index – for comparison of fixed income management performance
  • Bond Buyer Muni Index – for comparison of tax exempt income management
  • 90 Day T-Bill Index – for comparison of cash equivalent management