Equity Philosophy & Processes

Equity Philosophy

Targeted Return-Oriented Value
Specialist

Clients have absolute liabilities, whether they be pension liabilities or targeted distribution levels. These liabilities do not fluctuate with the returns of the financial markets. Many solutions designed to satisfy these absolute liabilities are relative return products. At Vaughan Nelson we construct portfolios with an objective of a targeted return. Our equity products seek to compound client capital at 15% annually.

Equity Process

Macro Analysis Combined with
Fundamental Research

Our equity products seek to compound client capital at 15% annually. We target this return by investing in companies that we believe can achieve a 50% return over a three year holding period, or 15% compounded annually. This targeted return approach leads us to seek any names that can generate our return objective, as long as they are within the market cap range of the relevant benchmark at the time of purchase. A company’s representation within an index is not a deciding factor on its inclusion in the portfolio. Consequently, all of Vaughan Nelson’s equity portfolios exhibit a very high active share.

3 Investment Categories

Three Ways to Generate Double
Digit Returns

When seeking names for our portfolios, we target companies that fall into one of three categories (Undervalued Growth, Undervalued Assets and Undervalued Dividend). Each category represents a distinct avenue by which an investor can earn a return. We seek a 50% return over 3 years from every position, regardless of category. The ability to rotate among these categories provides an ‘all weather’ aspect to our portfolios. This allows us to take advantage of market opportunities rather than reverting to the mean through time as a process moves in and out of favor.

Undervalued Growth:

  • Earning positive return on capital
  • Stable-to-improving returns
  • Not paying for future growth

Undervalued Assets:

  • Priced at a discount to asset value
  • Identifiable catalyst with ability to close valuation gap

Undervalued Dividend:

  • High, secure dividend. Typically 10%+.
  • Minimal basis risk
Bottom Up Process Coupled with Macro Analysis

Macro Analysis Combined with
Fundamental Research

While we implement a fundamental, bottom up process, we believe it is important to have a construct of the macro environment. We know that we cannot precisely predict interest rates, commodity prices, geopolitical events, or a host of other macroeconomic factors. However, we can consciously, deliberately and dynamically evaluate these factors for extremes. In so doing we can take advantage of what the market is ‘giving’ us.

Valuation and Risk Controls

The majority of the companies we evaluate will be run through a three-stage discounted cash flow analysis (DCF). The inputs to the DCF will be based upon our analysis of a company’s financial statements over the past seven years. We then model every line item on the income statement and balance sheet for the next five years. In this process we adjust the inputs as we see fit to appropriately recognize and account for what we believe to be the economic realities of the business. In addition to seeking a 50% return, we also insist on an asymmetric return outcome with limited downside.

Vaughan Nelson’s Risk Officer monitors the portfolios to ensure that actual exposures coincide with our intended exposures. A combination of vendor-provided risk analysis software, proprietary portfolio monitoring tools, and daily market data provide not only a view of our portfolios' exposure, but also insights into how the exposures affect performance and if market activity is conducive to our investment view(s). The Risk Officer monitors the portfolios and communicates findings to the investment team. The investment team then decides if any action is warranted.

Sell Discipline

We believe a sound sell discipline is critical both for capturing returns and controlling risk. We will sell out of a position for the following reasons:

  • Our price target is reached.
  • The reasons we bought a stock no longer hold true.
  • The company encounters a material increase in competitive pressures.
  • The company’s management team is no longer acting in the best interest of the equity investors.
  • We find a better idea.