Epoch believes that the key to understanding a company requires a focus on the cash generation drivers of the business – not a focus on accounting terms like earnings or book value. How does the business generate its free cash flow, and how does management allocate that cash for the betterment of the owners of the business; i.e., the shareholders?
It is the ability to generate free cash flow that makes a business worth anything to begin with, and it is the ability of management to allocate that cash flow properly that determines whether the value of the business rises or falls. There are only five things that management can do with a company's free cash flow: pay a cash dividend, buy back stock, pay down debt, make an acquisition, or invest in internal projects. If a company can invest, either internally or in an acquisition, and generate a marginal return on invested capital (ROIC) that is greater than its marginal cost of capital, then making that investment may increase the value of the business. But if the return is going to be less than the cost of capital, making the investment reduces the value of the business, and management should return the capital to the shareholders instead through one of the three methods listed above. Accrual-based accounting measures such as earnings, and valuation metrics based on earnings, simply do not provide the relevant information as to whether a company is successfully generating free cash flow and whether management is allocating that cash flow properly.
Our goal is to produce an efficient portfolio on a risk/return basis. We undertake detailed fundamental research on individual companies, diversify across attractive companies and economic sectors, limit individual holding sizes, and employ a strict sell discipline. If we have identified a good business at a good price, time is our ally as patient investors. As a result, we have relatively low portfolio turnover in most strategies. Epoch’s Investment Policy Group, representing the most experienced members of the investment team, provides a macro-level perspective that portfolio managers may use as a context when evaluating individual companies and sectors.
This is combined with rigorous quantitative and qualitative analysis that incorporates the following components:
- Analyze the business: Determine the sustainability of the business, earnings drivers, barriers to entry, and competitive advantages.
- Understand the cash flow structure: Focus on companies that generate cash earnings and assess the quality and character of those earnings to determine the net cash flow from the business.
- Relate cash flow to enterprise value: Examine relevant claims against net cash flow and determine the necessity of these claims to maintain and grow the business. Evaluate how management will use free cash flow. Value the cash flow stream and compare it to enterprise value to determine the attractiveness of the investment.
- Evaluate management quality: Identify managements with the intention and demonstrated ability to create shareholder value.
- Seek unrecognized assets: Uncover, where possible, hidden, undervalued or underutilized assets, especially in under-researched small- and mid-cap companies.
- Manage risk: Risk management is integrated into each step of the investment process. We have a team dedicated to quantitative research and risk management, ensuring that the portfolio construction process takes into account aggregation risks and diversification objectives. The goal is twofold: first, to minimize stock-specific risk through greater diversification, and second, to avoid unintended risks or biases at the portfolio level. A member of our risk management team is a co-portfolio manager of every strategy we offer. As a result, the lead portfolio manager is continually aware of these risks. While the research and security selection methodology is the starting point for all of Epoch’s equity strategies, the portfolio construction process is adaptable to the specific parameters of each investment strategy and our clients’ individual guidelines.