Financial Stability with Higher Probability of Success
Columbia Small Cap Value Fund I
Author: Ticker Magazine
Last Update: Apr 19, 11:24 AM ET
|Smaller companies do not always enjoy access to capital markets, suffering at times from lack of interest from investors, and all too often their disapproval. Even small caps with strong cash flows, solid balance sheets, and serious growth potential may be out of favor if investors are not satisfied with the generated rate of returns. Jeremy Javidi, portfolio manager of the Columbia Small Cap Value Fund I, focuses on exploiting this oversight by building a portfolio of companies with such characteristics.
“We look for companies with strong balance sheets but low ROEs because they are often discounted in the market. Our fundamental analysis helps us understand how their excess equity could be employed for our clients’ benefit.”
Q: What is the history of the fund?
The Columbia Small Cap Value Fund is a small-cap portfolio that was launched in July 1986.
Since I took over as manager in 2002, the fund has had a philosophy and process based on what we call “the trinity,” or three key attributes of companies in our investible universe that create a strong margin of safety and increase their probability of success.
Our investment process has evolved when presented with opportunities to improve, as it did five years ago after the fund experienced its only significant shortfall in absolute performance over the past 16 years.
In 2012, the 10-Year U.S. Treasury plunged. With this sudden and large decrease in the average cost of capital, lower-quality companies could seemingly create earnings by refinancing debt – something inconsistent with the philosophy of our high-quality, small-cap value portfolio.
We tapped into the vast resources at Columbia to better understand the market dynamics, and in doing so, came away with an important lesson: with 190 to 210 names, the portfolio was and is quite diversified. But because every name is consistent with our high-quality philosophy, if our philosophy underperforms, so will the fund – and in 2012, it did.
So, we took a deep dive into quality itself. When we peeled back the onion, we found two characteristics that are orthogonal to high quality: momentum and growth. Of the two, we believed growth was most consistent with a small-cap value portfolio like ours, so long as we were paying below intrinsic value for that growth.
Based on these lessons, and without straying from our core mandate, we made enhancements to the portfolio and the process by adding a growth vector. Although it sounds like a big hurdle, we now have another tool in the toolbox to help us try to obtain at least a 12% discount to intrinsic value.
The proof point of this evolution came in 2016 when the 10-year U.S. bond yields plunged again. Our performance was significantly better than our peers and benchmark, and we believe adding a growth vector has diversified the portfolio overall.
Q: What core principles drive your investment philosophy?
By centering on our trinity, we identify attractive, small-cap value companies trading at a discount to intrinsic value. When invested for a full market cycle, we believe these companies will tend to outperform.
Our core trinity is similar to a time-tested, Graham and Dodd approach. The first of its three parts focuses on high-quality balance sheets, the second on strong cash flows, and the third on discount to intrinsic value. The modifier we added five years ago identifies companies with good growth prospects.
Often, we see an opportunity set where others do not, because our fundamental understanding of high quality is different. When investors look at balance sheets, many define quality as a high return on invested capital (ROIC) or a high return on equity (ROE).
They frequently make the mistake that low ROEs are a hallmark of poor-quality companies. We have found this metric sometimes indicates exactly the opposite; many fine companies with strong balance sheets have low ROEs because they have been artificially depressed by an excess of equity.
We look for companies with strong balance sheets but low ROEs because they are often discounted in the market. Our fundamental analysis helps us understand how their excess equity could be employed for our clients’ benefit.
Q: What is your investment process?
Because the small-cap value universe we focus on is large and dynamic with upward of 1,500 names, wading through it takes a number of steps.
First, our quantitative research team puts together a statistical model that shows us what is cheap or expensive in the market, which provides us a great starting point to begin our fundamental research.
Even though I am the portfolio manager, I still spend a tremendous amount of time with companies. On average over the last four years, I have met with 500 companies annually. Also, I cannot give enough credit to the 23 senior research analysts and seven junior analysts of Columbia Threadneedle who have a strong understanding of the competitive landscape. We also lean on the guidance of industry experts.
Our focus is on remaining disciplined to our process and philosophy over a three- to five-year time horizon. We do not waste time on companies unlikely to meet our criteria, and will pass on those with poor balance sheets, poorly structured balance sheets, or that do not generate cash flow.
Q: Would you illustrate your research process with the help of an example?
American Equity Investment Life Holding, which sells annuities and life insurance products, is a company we have a long history with.
Last year, it was trading in the low-to-mid 20s. The stock had moved down, then back up, and there was concern about the energy bonds in its portfolio. We continued following the company; its indexed annuities were a growing part of the financial tools we needed for our investors, and although we felt American Equity Life was a good niche product, it became too expensive for us.
In April 2016, when the Department of Labor (DOL) rule came out, people had expected indexed annuities would be excluded. When they were included, the stock of American Equity Life fell 60% that day.
We quickly huddled together with our insurance analyst. Because of our familiarity with the company, we knew its balance sheet and cash flows were strong and that it had a good growth vector, so the main question for us was whether there was a sufficient discount to intrinsic value. Also, given the concerns over the company’s energy portfolio, we analyzed the bonds and determined there were not significant default risks.
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