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
- Emerging, high-impact new business initiatives are sub-scale and are not yet visible to investors
- Companies possess a complex business model or misunderstood asset base
- Company specific strengths are ignored due to an uncertain industry outlook
- Differences arise in analytical perspective (time horizon)
Our efforts to identify these opportunities takes on several forms: criteria based financial screening, referrals from our industry contacts, and our own in-depth knowledge developed over more than 20 years of public market investing. PCM’s screening process and broader investment approach is not limited by the market capitalization of a company. Instead, our size enables us to become meaningfully involved in investment situations that many investors consider too small for consideration.
In identifying opportunities, PCM’s investment leverages its 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 making financial statement adjustments to better reflect the true value of the company’s assets and liabilities, as well as to identify any potential “footnote” risks such as underfunded pensions, off-balance sheet liabilities, environmental liabilities, aggressive accounting procedures, etc.
In our experience, free cash flow is a superior measure for long-term investors.
A common characteristic of superior businesses is their ability to generate sustainable and growing free cash flow. PCM defines free cash flow as cash flow from operations less 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 and variability of the anticipated cash flow stream.
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
- 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. Reaching for this confidence level makes sense for us; our expectation in most situations is that we will be investors in this company for 3 to 5 years, and we may also be one of the company’s largest shareholders.
Our qualitative management review includes an evaluation of each company’s leadership:
- Compensation practices and perceived goal congruency with shareholders
- Candor with PCM and willingness to engage with long-term shareholders
- History of creating (or failing to create) value for shareholders
- Intellect, ability, innovation and focus – can this management group close the valuation gap?
- Insider ownership (including recent trading activity) by management and company directors
- Perceived quality and objectivity (independence) of the company’s directors
In the course of our qualitative business assessment, we often seek input from (among others) industry competitors, suppliers, customers and other knowledgeable industry participants. The objective of this review is to ensure that in addition to being statistically attractive, that we also identify a durable franchise with relevant products and services and defined market segments in which the products have a niche or unique value proposition making them difficult to displace.
PCM’s qualitative business review seeks the following:
- A thorough understanding of the market dynamics for the industry in which the company operates
- Know the competitive risks from other industry operators and their potential to take market share
- Understand management’s commitment to (or answer to) innovation and new product spending
- Review sales team skill and record of success – does company’s sales team execute well?
- Consider any secular threats that may relegate this investment to “value trap” status
- Review ownership of the stock – have activists taken positions and what might they propose?
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. We understand that manageable risk and near-term uncertainty may underpin or contribute to a compelling valuation. However, we also understand that some risks are “un-analyzable” and our responsibility is to move on to the next idea.
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.
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.
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.
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.