Cost of Capital Beaters
Polaris Global Value Fund
Bernard R. Horn, Jr.
Author: Ticker Magazine
Last Update: Oct 31, 10:47 AM EDT
|Companies generating profits exceed their cost of capital, display healthier business profiles, and are also attractive investments, especially if their stocks are out of favor for temporary reasons. Bernard R. Horn, Jr., president of Polaris Capital Management, LLC and portfolio manager of the Polaris Global Value Fund, builds his portfolio from this narrow list of stocks discovered from around the world.
ďWe believe in a strictly disciplined approach, to only invest in a company when itís priced to beat the benchmark.Ē
Q: What is the history of the fund?
I started managing global equity accounts for individuals back in the early 1980s, and by 1989 I decided it would be far more efficient to pool these accounts into one fund versus manage separate accounts. So the Global Value Limited Partnership began in July 1989, but when we hit the threshold of our investor limit, we converted it to this mutual fund, the Polaris Global Value Fund, in 1995. It is now our flagship product.
Today, the fund is just over $500 million, and the firm has over $10 billion under management total. Most of our business is sub-advising other funds, but we manage this fund on our own.
Q: What are the underlying principles of your investment philosophy?
We believe in a strictly disciplined approach, to only invest in a company when itís priced to beat the benchmark. We calculate what we call cost of capital, Polarisís Global Cost of Equity, by adding 2% to the benchmarkís historical return after inflation, plus another measure to cushion against currency fluctuationsóthat number differs by country and is basically the real bond rate in that country.
So, for a country with a 1% real bond rate, if the benchmarkís historical rate of return after inflation is 7%, that plus another 2% equals 10%, and thatís our cost of capital. If a company isnít poised to beat that, it doesnít make it into the portfolio.
Q: How does this philosophy translate into your investment process?
We have a database of 40,000 companies which we distill down into about 75 holdings. We screen the database using a variety of value measures, the primary one being that a company has to generate sustainable positive cash flow.
It must also have sufficient cash flow to cover its maintenance capital spending. If it does, the value of that spending relative to the firmís market capitalization has to meet our required rate of return for that country.
Itís a very bottom-up analysis, but while we consider macro factors, thatís not part of our fundamental work. We are primarily concerned with the particular niche the company occupies, and whether itís a sustainable and growing business.
We are benchmark-agnostic when it comes to what companies get through our screens. Any company that meets our rate of return requirement is fair game, no matter what size it is or where it is situated, in terms of both geography and industry. So, even if we donít particularly like the sector or the country, if a company passes our screening, we look at it, no exceptions.
We donít always know where the best values are, and that often leads us to shift the portfolio. We might be light or we might be overweight emerging markets, for example, but that asset allocation as to where clients should invest their money is a decision we are in a position to make because we survey where the best values in the world are, every day.
Q: How would you describe your research process?
After we do our initial cash flow screening, we analyze the companyís financial reports to see if they align with our findings. There may be minor differences but for the most part, our screens are fairly accurate. The quantitative data available on companies around the world does omit certain important measures, however, which is when we look at the companies individually. After that, we look at the industry and decide whether itís a sector that looks promising to us.
Once we judge that a company looks like it has a sustainable future, then we build a financial model, a long checklist of items that require considerable management contact to uncover, for example, financial statement analysis, balance sheet, income statement, and cash flow.
We want to understand the business model and spend a lot of time talking to management about their plans to sustain cash flow and what they intend to do with the leftover cash flow after reinvesting to maintain the company. We want it to grow, but with limited downside risk.
We look at its competitors to determine where the company fits into the competitive environment and whether they possess sufficient competitive advantage to allow them to withstand competition, even when the economic cycle is weak.
In terms of cash flow, we are conservative in our estimates to protect our downside as much as possible. Only then is a company presented to the investment team for further analysis and discussion.
Itís important to note that, typically, the companies that pass our screening are not darling stocks. They are cheap for the very reason that some investors view them negatively.
If a company can survive our process, there is a good chance it will be added to the portfolio. And when we add something, we generally must sell something else, something that doesnít represent as good a value or outlook.
We have made many more changes this year, shifting the portfolio more toward Asia, and away from Europe and Scandinavia where we have had overweight positions for quite some time.
Q: Can you furnish some examples of your research process?
One example is Magna International Inc., a Canadian automotive supplier. It has a good diversified car parts business and itís been inexpensive for a while. It came into our rangeóU.S. car sales have been a bit weak, relatively speaking, so some of the auto parts stocks have come down a bit.
From a sector perspective, the number of parts suppliers has substantially reduced over the years, primarily because OEMs, the original equipment manufacturers, often make their suppliers invest quite a lot in research and development, tooling, practice runs, etc. It wasnít unusual for an OEM to change its mind and send the little parts company out of business because it couldnít afford to sustain those sorts of losses.
Nowadays, itís just a few parts suppliers responsible for keeping the OEM production lines running, at a level of millions and millions of parts.