Moderate Allocation Strategy : Selection Process

With the goal of regular income generation and capital preservation, our selection process and weighting of stocks and bonds demands a significant amount of rigor. Moderate Allocation Strategy holdings may consist of 40-70 stocks at any given time, with decision-making partly influenced by the attractiveness of the stock. For bonds, a heightened level of scrutiny, based on investment quality, is employed. In terms of capital preservation, we seek out highly leveraged companies and also hold cash when we think it is the best course of action. Ultimately, this process provides what we believe to be a good balance of risk and reward.

Equity selection methodology

The key to strong performance lies in staying flexible. Our collaborative process allows us to take advantage of investment opportunities when they present themselves.

Equity Selection Process
 

Step 1: Identifying opportunity

Promising investment ideas can come from anywhere. Our analysts have developed expansive networks of idea sources. They read widely; attend industry conferences and talk to customers, suppliers and competitors of portfolio companies.

Our analysts are generalists, yet each has multiple circles of competence. They use their expertise to identify those characteristics that we have found maximize our odds of success. The importance of these characteristics can carry vastly different weight depending on sector products, economic cycle, competitive landscape, and more. However, quantitative, qualitative, and macroeconomic factors are almost always taken into consideration.

 

Step 2: Business analysis

Once a potential investment has passed our initial criteria, our analysts begin a deeper qualitative study to ensure the company's specific characteristics meet our qualifications. Through a thorough review of company financials, operating and investing track records, competitive positioning, and often a personal meeting to assess the management team, we are able to determine how the investment opportunity stacks up against our discipline.

We believe that the value of a business is a function of the cash that its owners will be able to take out of the business over time. We look for businesses that:

  • Have understandable products and services
  • Hold strong competitive positions
  • Are capable of generating excess cash flow
  • Employ honest, intelligent management
 

Step 3: Business valuation

In conjunction with our qualitative due diligence, we forecast a company's free cash flow using various economic and company-specific scenarios. We identify and focus on the business' key drivers with an understanding that two or three assumptions often make or break an investment. We frame the business' reinvestment opportunities and likely uses of excess cash flow, paying careful attention to management's understanding of appropriate capital allocation. Our analysts then assign an estimate of what an informed buyer might pay to own the entire company outright.

Objective value

We use a five-year DCF model with a 9% equity discount rate. Base, high and low case business value estimates are determined.

Targeted value

When a stock price is at least 30% lower than base case value, we're interested.

If we like the business, but the stock price does not reflect the discount we'd like to see, we will put the company on the "on-deck" list. As long as the objective value of the company remains stable, a reduced stock price may move the investment into the range in which we'd consider a purchase.

 

Step 4: Writing the company report

The sponsoring analyst summarizes the recommendation in a written report for review by our Investment Team. The report provides a detailed investment thesis, supporting rationale, an industry overview, and a summary of our assumptions and the key risks to the business. Areas of focus include:

  • Sources and sustainability of competitive advantages
  • Potential weaknesses and vulnerabilities
  • Understanding of consensus views and where we differ
  • Estimated valuations
  • Key drivers that will make or break the investment
  • Porter's Five Forces Analysis
 

Step 5: Vetting the investment idea

All members of our Research Team vet each idea, asking tough questions rooted in the principles of the Weitz Way. Recommendations are either:

  • Purchased
  • Placed on the on-deck list awaiting a more attractive price
  • Determined to require additional work and put on the watch list
  • Dismissed altogether
Selection Debate
 

Step 6: The portfolio managers

Ultimately, decision rights reside with our portfolio managers. While research and maintenance are a collaborative effort, portfolio managers are accountable for where and how much to invest.

Our managers are responsible for weighing purchase considerations, including the price-to-value ratio of a specific stock (as well as the ratio compared to other potential investments), range of potential outcomes, and exposure to similar risks portfolio-wide.

In addition to purchasing, all of our portfolio managers have ongoing portfolio management and risk management duties, including:

Portfolio Management

  • Maintaining concentrated portfolios
  • Investing with a long term (5-10 year) investment horizon
  • Remaining benchmark agnostic
  • Willingness to hold cash when appropriate
  • Emphasize ongoing collaboration between analysts and managers including quarterly business valuations and daily communication with analysts

Risk Management

  • Defining risk as permanent loss of capital – not price volatility
  • Considering risk at every stage
  • Adherence to Ben Graham's "margin of safety"
  • Assessing special risk factors that may affect multiple holdings
  • Avoiding hard limits on position sizes
  • Defining 5% as a "full" position
 

Our Exit Strategy

Diligence is equally important when it comes to selling any given stock. Our goal is to maximize return without taking unnecessary risks. Our specific standards for selling investments are:

Standards for Selling

Fixed income selection methodology

We use a dual approach to bond investing, blending top-down and bottom-up research methods.

Equity Selection Process

 
Step 1: Idea generation

Our team continuously investigates new issues and monitors secondary markets to maintain our solid understanding of the investment landscape. Ongoing communication between team members promotes the cross-pollination of ideas. We leverage our equity analysts' expertise and uncover additional income generating investment opportunities that other portfolio managers might miss.

Our understanding of the bond opportunity landscape includes reviewing:

  • Daily list of new issues
  • Company filings
  • Secondary market quotes
  • Investor presentations
  • Conferences and periodicals

 
Step 2: Credit/collateral review

When we evaluate a potential security, we start with extensive bottom-up research. Our internal investigation process includes pointed questions to ensure that our final conclusion is based on sound reasoning as well as financial data. We operate as our own devil's advocate, rigorously investigating companies, testing our calculations and verifying our thesis before we commit.

Corporate credit considerations

  • Financial statement analysis
  • Management's stated leverage target
  • Past relationship with creditors
  • Pricing power
  • Cyclicality
  • Inflation
  • Capital structure and debt maturity profile
  • Issue that offers the best risk-adjusted return

Mortgage-backed securities considerations

  • Loan-to-value
  • Pool size
  • Servicer
  • Geographic concentration
  • Frequency/severity of default
  • Delinquencies
  • Percent of real estate owned
  • Credit support

 
Step 3: Due diligence

In this phase, we equip our team with documented investment rationale and then open the floor for debate. We challenge assumptions, vetting every new idea thoroughly before it advances to our approval list.

Due Dilligence

 
Step 4: Valuation/return on investment (ROI)

Once we've completed a thorough investigation of each investment opportunity, we calculate a specific valuation of the investment opportunity or potential ROI, depending on the type of investment.

Corporate credit

To evaluate corporate credit opportunities, we calculate valuation ranges in relation to base case and downside case assumptions, taking the following into account:

  • Enterprise value-to-earnings before interest, taxes, depreciation and amortization
  • Private market value
  • Net asset value
  • Liquidation analysis

Mortgage-backed securities

When reviewing mortgage-backed securities, we calculate potential ROI using cash flow assumptions based on three possible future pre-payment speeds (three cases based on probability of occurrence) and credit-related assumptions, where relevant.

Treasuries

For treasuries, we calculate “real” returns by adjusting nominal returns for inflation.

 
Step 5: Portfolio and credit monitoring

We use multiple sources for monitoring the portfolio and credit standing of all our income investments. These ongoing reviews help solidify any bond's position in our portfolio:

  • Ongoing, open dialogue about any potential credit issues
  • Daily review of company news/events
  • Daily review of overall credit fundamentals
    • Spreads
    • Interest rates
    • Defaults
    • Economic indicators
  • Quarterly internal credit review
    • Operating performance
    • Credit metrics
    • Industry dynamics
    • Financial outlook
    • Financial model update

 
Our exit strategy

By diligently keeping tabs on related news, credit fundamentals and potential credit issues, we identify when we believe any of our investments begin trending into a level of unnecessary risk or are no longer profitable. In addition to bonds maturing, the following are reasons we may decide to sell a bond investment.