Investment team revels in volatility

The volatility that rocked the markets from late July through the end of August could well be the start of a longer-term trend. When there is no rising tide, clients need to rely on experienced security selection teams to raise their fortunes.

EdgePoint Wealth Management might not be a household name, given its marketing budget—zero—but its founding partners are well known to financial advisors across the country.

And these gentlemen are not afraid of market dislocation.

“Volatility is always good if you know the true value of a company,” says Geoff MacDonald, one of the founding partners of the firm. “An awful lot of people in the stock market don’t like volatility. The reason why people often can’t handle volatility is they don’t know what their investment is worth.”

MacDonald says investments are the only purchases people make without knowing the value of what they are buying. They may know what a camera is worth, or a pair of jeans or a new car. But when it comes to the stock market, many investors buy based on momentum, interest rates or the infamous hot tip. These bad investment decisions are just fine with him.

“It gives us a wonderful opportunity to buy businesses for less than they’re worth,” he says. “This last month has been an exceptional time for us.”

The investment decisions made in August 2011 will have a definite impact on the funds’ performance over the coming years, he says.

“You have to always be looking to buy growth and not pay for it, but that’s exceptionally important in today’s world,” says Tye Bousada, the other founding partner of the firm.

Globally, markets face stiff economic headwinds—high unemployment, sovereign debt risk, high personal debt levels—which will persist for years to come. Since the vast majority of companies rely on economic growth for their own profit growth, there’s a good chance the markets will remain choppy for the next three-to-five years.

“In that type of environment, you have to find the minority of businesses that can grow irrespective of what happens in the economy and not pay for that growth today,” he explains. “When fear is ever present in the market, it becomes easier not to pay for that growth.”

Despite their focus on the growth prospects of each investment, they are loath to call themselves “growth managers.”

There is a strong desire among fund analysts, advisors and investors to place portfolio managers within a style box: either large-cap or small-cap; value or growth. Some managers see value in remaining true to one of these pigeonholes, and this can affect their investment decisions.

“We don’t manage in that fashion. The quadrant that we’re looking for is the ‘make money’ quadrant; we want to be in that one,” Bousada says. “If someone came in and said: ‘You used to be in this quadrant, and you’ve shifted over to this quadrant,’ that wouldn’t concern us too much.”

A quick glance at the Morningstar style map bears this out. The EdgePoint Canadian Portfolio’s weighted average lands pretty close to the centre of the overall grid, with a slight bias toward larger companies on the value side. The Global Portfolio is similarly medium-high on the cap weighing, but tilts toward growth.

Besides, the separation of growth from value is artificial, MacDonald argues.

“How do you value a company without knowing its growth?” he asks. “The value of any business is the cash you can put in your pocket every year as the owner of that business. The business is not worth any more or less than that.”

Investment Philosophy Free cash flow is key to the investment process; what management of the company does with that cash is less important. Dividends, stock buybacks or simply plowing the cash back into organic growth are all acceptable, as the pair say they trust the management of the firms they invest in.

“We don’t have any black box or supercomputer that tells us when to buy something. We’ll look at basic methods like price-to-earnings, but we’ll also look at enterprise value to free cash flow,” Bousada says. “There’s nothing untraditional about our evaluation metrics at all. We’re not trying to reinvent how to value businesses.”

Their investment process is focused on two elements: risk and growth, although they say their approach to each differs from the rest of the market.

“The vast majority of the market defines risk as volatility,” Bousada says. “We think that’s the wrong definition. We define risk as the opportunity for permanent loss of capital.”

An archetypal example of this might be the 55-year-old investor who, in 2000, feels he is being left behind by the dot-com boom. He shifts his assets into the tech sector just before it collapses.

“You just experienced permanent loss of capital. After you do that, you’ll not make your money back, after accounting for inflation,” Bousada says.

That example is not as isolated as it might sound. Similar bubbles burst on a regular basis: in the 1970s, it was oil; in the 1980s, Japan; the early 1990s, emerging markets; late 1990s, technology. In the 2000s, the bubble was real estate, for much of the developed world.

“We approach each business as if it’s a business that’s going to feed our family and put a roof over our head,” he says. In the case of EdgePoint’s staff, that’s literally true. “The majority if our worth is tied up in the portfolios. If you work at EdgePoint you have to own the portfolios.

“When you approach risk in that fashion you’re looking at different types of risk.”

Among the risks they watch for are those that can affect revenue growth and margins, management succession, barriers to entry, and “the risk of not knowing what you’re doing.”

Says Bousada, “The last one is probably the toughest one to wrap your arms around, but it is legitimately the one that has kept us out of the most trouble over time.”

Throughout their careers, he says the pair have steered clear of once marquee names that have later blown up.

“Were we smart enough to know they were all going to go to zero? Absolutely not,” Bousada say. “We took a look at AIG when the share price was cut in half, thinking there might be an opportunity. But the reality was, you look at the annual report and it doesn’t take long to realize you don’t know what’s going on inside that business and you don’t want to own it.”

The EdgePoint Canadian Equity Fund is a concentrated portfolio of between 30 and 50 of “feed your family” companies, but there are no mandated constraints on the portfolio sizes, MacDonald says. In the past, the Canadian fund has included as many as 60 names. The Global fund tends to range between 25 and 40.

“Once you start getting up in the high 30s or 40s, more often than not, [companies] 1, 2, 3, 4, 5, 6, 7 [are the] best ideas in the fund [and] just blow the socks off the 40th,” he says. “You just stare at the 40th best idea, day in, day out, comparing it to even your 15^th [best idea]. And eventually you come to the realization there’s no comparison. So it’s really hard to get above 40 names.”

Neither the Global nor the Canadian mandate has capitalization constraints, but smaller-cap names are rare within the global fund. MacDonald says they are more comfortable with Canadian small-cap stocks because they are able to meet with management teams more frequently.

With an eye toward buying growth at a discount, Bousada says he would be comfortable with a substantial cash position. But this has never risen above 15% in his career, he says, because there has usually been an opportunity at hand.

“If a 5% name gets taken out of the portfolio, it’s in cash,” Bousada says. “We are not compelled, within the next day or the next week, to find an investment. The cash range is fixed on finding opportunity to make people money without taking silly risks.”

On the Global fund, it’s easier to find a company to replace the one sold from the portfolio, so cash is usually redeployed more quickly. Again, the absence of constraints helps.

“If you’re living in just big-cap-land and your universe is 400 companies, then there will be periods when you might get extremely uncomfortable being invested,” says Macdonald. “You can go over the universe every 30 days and stare at it and just say I don’t feel comfortable.”

For more on EdgePoint’s target market, history and view on ETFs, see the September issue of Advisor’s Edge Report.