Q: What is the history of the fund and how has it evolved?
AB Discovery Value Fund was designed to exploit sizeable inefficiency created by a sharp drop in published sell-side research on smaller U.S. companies on Wall Street. Launched on March 29, 2001, the portfolio seeks small- and mid-cap value stocks with idiosyncratic return potential and an investment catalyst.
Not only does the smaller-cap universe lack research coverage, but also it has become far more global in nature over the last 20 to 25 years. Our process combines a focused research analyst team that leverages AB’s significant global research footprint across equities and fixed income to generate ideas, research companies, and construct the portfolio.
We focus on identifying investment catalysts because we believe they mitigate some of the volatility inherent in small caps as well as lessen anxiety when value is out of favor. During periods when the market or an industry is facing difficulties, there are still individual companies showing improvement, perhaps due to cutting their cost structure or returning capital to shareholders.
The fund has evolved gradually through fine-tuning. It’s crucial that we consistently refine our investment process by identifying areas for improvement and discovering ways to effectively generate greater alpha. For instance, we track each of our investment decisions to assess how we may have been able to improve overall performance, or if a certain company ends up being a more successful investment than others, we evaluate why. Compared to ten years ago, we’ve become better focused on particular types of catalysts and have increased the degree to which we collaborate with the firm’s global analysts.
Q: What core principles drive your investment philosophy?
We believe active managers can add significant value by exploiting an extremely inefficient asset class, and to do so, our approach combines deeper value with investment catalysts. Through this perspective, we focus not only on things like balance sheets, but also identify companies trading at attractive multiples based on an in-house view of their longer-term normalized cash earnings – and we know what to pay for them.
At the same time, we look for an investment catalyst which can force recognition of value within a short timeframe – generally, two to three years. It’s important to stress that these catalysts aren’t related to macro-economic development or economic policy. Although we acknowledge these from a risk perspective and want to understand the impact on our companies, they can’t be the primary investment catalysts because our ability to forecast them is by definition more limited.
Q: What is your investment process?
Our process begins by generating initial ideas, combining both fundamental and quantitative approaches to create a single list of promising stocks. For the fundamental perspective, I go through each company we want to add to our research queue with the portfolio’s other manager, Shri Singhvi and the analyst covering it. At any given time, we are actively researching a number of candidates for the fund.
Next we discuss underlying investment catalysts and the companies or industries where these might be found. Catalysts can be things like new management teams that are restructuring the company, shifts in behavior like when an existing management team is returning more capital to shareholders, or an inflection point in an industry where the company competes.
Quantitatively, we tap into enormous resources which help pinpoint companies that are more likely than not to have deeper value. Additionally, we look for characteristics that might indicate an inflection point – perhaps a company’s share price is starting to reverse or its short interest has begun to decline.
Q: How does your research process analyze catalysts?
It’s a two-step process which includes triage and research review. Triage is a relatively short effort to assess whether an idea is promising enough to do a deep dive on. Since ultimately we must be able to defend any stock that ends up in the portfolio, triage arms us with the necessary research.
During triage, names may be eliminated if their catalysts are entirely macro or if we don’t believe we can generate differentiated research insights about the company’s earnings power.
Once deemed worthy of a deep dive, we take the company apart by talking to its management, customers, competitors, and suppliers. As part of this work, we leverage insights from AB’s global research analysts to better understand the company’s competitive position. Our goal is to incorporate global insights and fundamental perspectives to determine what a company can earn, what the range of outcomes may be, and how we feel about the investment catalyst.
Collaboration is critical to this deep-dive approach to fundamental research. Our analysts bring insights into how they look at smaller companies and their global peers. For instance, if a U.S technology company is competing or selling goods in an Asian marketplace, we have analysts in Hong Kong and can leverage their knowledge.
After dissecting a company, the next step of our research process is to review the research itself. We examine the underlying values of our forecast, the investment catalysts, and the risk we think is inherent within a company – basically, assessing our assumptions. Considering downside cases for every stock is critically important. We delve into risk – not only the risk inherent to the company, but also the risk underlying its ability to deliver the normalized cash earnings we anticipate.
A set of quantitative tools helps us determine the impact of adding a stock to the portfolio, determining the risk penalty should it become more concentrated, or the benefit should it become more diversified. Ultimately, our buy decisions revolve around understanding what a company’s potential return may be and our confidence in the investment catalyst.
Q: Can you give some examples to illustrate your research process?
The industrial sector held opportunity a few years ago, specifically in trucking. We identified a number of stocks that had sold off which had some of the characteristics we seek. Some had new management teams and others showed shifts in management behavior in terms of returning cash. Additionally, there was an inflection point in the trucking niche.
We started adding names to the queue. Some were quickly discarded; either they didn’t have valuations attractive enough to pass our triage or deep-dive process, or the investment catalyst wasn’t sufficiently compelling. Those that met our thresholds had characteristics like company-level catalysts that would drive improving earnings and cash flows, operating leverage, and strong balance sheets.
To better understand these companies and the competitive dynamics of carrying freight, we talked to management, and in the cases when a greater sense of freight patterns was needed, we spoke with retailers as well. The knowledge we took away regarding specific companies was then combined with our views on their valuation and earnings, determining which, if any, might be considered for the portfolio.
Q: What drives your portfolio construction?
It is constructed using a bottom-up stock selection process with industry exposures being a function of where the best opportunities are. A set of quantitative tools helps us better understand the risks of being over or underweight an industry so we can better assess if the potential returns we are forecasting justify the risk..
Our capitalization range is close to that of the Russell 2500 Value Index, the fund’s benchmark. Generally, new purchases fall between $1 billion and $5 billion. Because we don’t sell stocks arbitrarily when they go higher, part of the portfolio will be above that threshold. When we do eventually sell, it is either for risk or valuation reasons.
The philosophy of the portfolio – identifying deeper value with a catalyst approach – plays out in its construction as we look to exploit the inefficiencies in small cap. As a value portfolio in a smaller-cap environment, by definition our companies have a bit more volatility and we are comfortable with that. Being comfortable, though, doesn’t mean we aren’t mindful of risk.
Once we decide to purchase a stock, the portfolio does have ranges for position sizing; new ideas generally range from 60 basis points to 120 basis points.
Q: How do you define and manage risk?
Our perspective on risk is inherent through our entire process and allows us to efficiently identify differentiated levels of alpha without incurring excess risk. The trade-off for finding attractive idiosyncratic return opportunities in the smaller-cap space is that the penalty for getting research wrong is significantly higher than in larger cap. While active managers can add a lot of value by exposing the portfolio to active returns, we spend a great amount of time understanding a company so we can prudently ensure we are paid for that risk.
The firm has a risk group that operates independently of the equity group and which also monitors the portfolios. As well, a robust set of internal and external tools allows us to look at risk from a number of different parameters making certain the fund isn’t exposed to unintended risks.
