Lowell Road Asset Management Equity Investment Strategy
At Lowell Road we believe in sticking to a process no matter what short-term results occur. Over a long period of time we expect to provide our clients with market outperformance through rational investment decisions. We will not be swayed by our emotions like our fellow market participants, but we will take advantage of their low selling prices in relation to business value.
We make it our mission to continually improve on our investment process. However, we will not be fooled by randomness. If an outcome, whether positive or negative, is attributed to either good or bad luck it should not affect us. If we make a mistake and that mistake is attributable to our faulty analysis we will learn from it and refine our strategy.
The process starts with idea generation. We cannot possibly look at each and every one of the thousands of publicly traded companies. One method we use for idea generation is screening through these names to find the cheapest companies on an EV to EBITDA basis.
The EV to EBITDA measure is also known as the acquirer’s multiple. When acquiring a business one has to buy not just the whole equity of the company, but also now owns the debt and cash as well. EV simply equals Market Cap + Debt – Cash.
EBITDA or earnings before interest, taxes, depreciation and amortization, puts companies with different tax rates, debt levels, asset levels all on a level playing field. While a business may not be generating significant free cash flow it could be producing significant EBITDA.
Buying fundamentally cheap companies is a statistically proven method to generating high investment returns over many years. While buying companies that have low prices and low expectations is difficult to stomach, lower prices translate to higher returns in the future.
In addition to looking at companies that trade at low EV to EBITDA, we also generate ideas from 52-Week low lists, multiyear leading decliners, and industries in cyclical troughs.
On average a stock moves 50% a year from its low to high. While it may seem contrarian, we would rather buy a stock that just hit its 52 week low, rather than its 52 week high. As we have recently learned, a stock price can decline even further after it hits a 52 week low. We consider ourselves to be value investors, not technicians, but we do have respect for the momentum of stock prices in either direction.
Once we have a narrowed down a list of companies we comb through this list looking for simple, understandable businesses within our circle of competence.
After we pick a business that looks cheap and is within our circle of competence we begin our analysis.
We read the annual reports and listen to the conference calls. We try to get a better understanding of where their revenues come from by product or service and geographically. It’s important to have an understanding of what challenges and opportunities the business faces.
We look at the management team and board of directors. After all when a business is generating cash the shareholders do not make the decisions on where capital is allocated, the management team does. It is important to have a management team with a record for prudent capital allocation to ensure a good return on invested capital, which translates to a return on the stock price. We want to buy a business that is undervalued today, but also buy one that is creating value for tomorrow.
The intrinsic value of a business is dependent upon the future cash flows it generates. While we can’t pin an exact number on the value because the business is always changing, we can come up with a range of values. Simple businesses in industries without rapid change are easier to value because their cash flows are easier to estimate. If the company’s market price is lower than the range of intrinsic values we come up with, then a margin of safety exists. Depending upon how large of a margin of safety exists, we will make a decision to purchase the company in question. The larger the margin of safety the better.
We currently have our best 12 ideas in a portfolio, equally weighted from the price they were purchased at. Only owning 12 stocks is considered a concentrated portfolio. The benefits of diversification are fully realized at around 20-30 stocks. Mutual funds own 50-100 stocks on average, which in essence makes them index huggers. We don’t want to invest in our 50th best idea.
Having a concentrated portfolio forces us to be convicted about our ideas and understand them well because they will have a significant impact on our performance. With a concentrated portfolio our performance will not hug the index’s performance. Concentration causes our record to be volatile, but we’re willing to accept greater peaks and valleys of performance.
Having too many stocks in a portfolio makes them difficult to follow. We doubt most mutual portfolio managers are knowledgeable on all the 50-100 stocks in their fund.
Selling is one of the most difficult aspects of any investment manager’s process. Often times a stock will run up after you sell it. Other times a stock will decline right after you buy it.
If things work out the way we expect, typically we sell a stock after at least a year of ownership to benefit from long-term capital gains. If a stock is down for the year we may take advantage of the short-term capital loss.
If the price gravitates toward the business’s intrinsic value or well above it a decision to sell is considered. If the market reacts positively to news of a takeover or merger we will sell.
Our investment process is based on the insights of many successful investors. We are committed to continually improving our strategy to provide satisfactory returns for our clients. We will not stray from our value investing roots or let our emotions get the best of us. If you have any questions about our approach please feel free to contact us.