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.”
After just a few hours of analysis, we ended up purchasing the company for around $12.85. Having access to outstanding analysts and capable teams gives us the fundamental horsepower needed to take advantage of dislocations like this in the market. Currently, the stock is trading in the mid 20s.
Q: What influences your buy-and-sell decisions?
Intrinsic value is not a static number, so our decisions are not based on target prices. We do, however, set intrinsic value targets.
We continually assess the intrinsic value of our companies, making sure there is sufficient enough discount to intrinsic value to continue to hold. That 12% discount is always our guide post, and we generally rely on dividends for a safe and secure portion of that risk-adjusted return. To determine whether an underlying security has enough potential capital appreciation, we use price limits with probabilities around them.
There are three reasons for us to sell securities. The first is if a stock has appreciated to a fair value and no longer presents any significant upside.
Second, because the fund is pure small-cap value, we sell when stocks change their characteristics, for instance, if they appreciate past the upper end of the Russell 2000 Value Index, which is our benchmark, or if they become more of a growth play than small-cap.
Third, we sell when we were wrong. Sometimes things change – in the market, the competitive landscape, or in a company strategy – and are no longer congruent with our mandate. When this happens, we reassess the situation and sell, hopefully at a gain for our clients, but maybe not meeting our total return threshold.
Q: What are some important considerations for you in portfolio construction?
We manage 200 names in our portfolio, and being completely consistent with its construction is critical to us.
Looking across various small-cap value funds, they tend not to be able to maintain performance as their assets under management (AUM) grow. Instead, growth comes by adding name count or by migrating up market capitalization toward more liquid mid-cap names.
In 2002 when we took over this strategy, we made a pledge to our CIO we would not do this, that the fund would remain disciplined and invest in same kinds of companies until 2017 and beyond – and today, our AUM are approximately $1.2 billion.
We invest across the whole small-cap spectrum. The smallest name in the portfolio has a $90-million market cap and the largest is a company with a $5-billion market cap.
Our portfolio is diverse, and we want to make each of its 200 names count. I think of it as if it were a baseball team, and each of our holdings is a baseball player. Every day between 9:30 a.m. and 4:00 p.m., each player has to go out and take a swing. If a portfolio is weighted incorrectly, only the swings of a couple of those batters actually matter.
This is important to us when thinking about portfolio construction. If we mismanage weightings, only a precious few names actually determine the whole portfolio.
So, we use our own weighting scheme to ensure every name in the portfolio is contributing to active risk and to total return. It considers the liquidity, volatility, and potential upside of each security.
The biggest problem in portfolio construction occurs when people bet only on their highest conviction ideas; many people do not understand the risks and ramifications of doing so.
Sometimes our highest conviction ideas – like biotechnology companies – are the lowest weight in the portfolio, while some of our lowest conviction ideas – like utilities – tend to be our highest weights.
Why? Because the potential volatility of a utility company is significantly lower than that of a biotech. So holding 30 basis points of a biotech company might express far more conviction than a utility representing 1.2% of a portfolio.
We also use 13 thematic baskets when constructing the portfolio. They represent long-term tailwinds we have identified to the U.S. economy. These are not fads, but are tailwinds like water scarcity, the Internet of Things, infrastructure, aging population, and agriculture.
These themes are used in our portfolio construction because although we think the classic GICS sector view is helpful, it is also flawed. Our themes tend to run across a number of sectors, so using them gives us a better holistic view of what our clients are being exposed to. For example, when we talk with a company dealing with one aspect of infrastructure, that information can be used to increase our understanding of all companies with exposure to that same theme.
While our construction is benchmark aware, we are by no means benchmark dependent. Currently, 27% of our names are not in the benchmark.
Over long market cycles, turnover has remained between 25% and 40%. But we are quite flexible, and when times change, so do we. We see market dislocations as opportunities to shift the portfolio.
Last year, we repositioned the portfolio after seeing a significant risk due to the valuation of sectors like utilities, and lowered our weight there. Toward the end of the year, we significantly reallocated weight toward healthcare, an area we had been underweight for almost 18 months.
The portfolio’s overall turnover has a weighted average holding period of four years. Names in diversified financials are held, on average, for eight years; insurance companies, seven years; and banks, 5.5 years.
Compare those to areas we are excited about today because of dislocations in the market – areas like energy, where our average holding period is 1.6 years, and healthcare, where it is just 0.7 years.
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