Q: What is the history and objective of the fund?
In 1994, the Johnson Opportunity Fund was launched to provide diversified exposure to mid-cap stocks for private clients within an equity allocation. In 2013, we broadened the fund’s scope to include small-cap stocks and now invest in U.S. companies with market capitalizations ranging from $300 million to $15 billion. Our firm, Johnson Investment Counsel, was founded in 1965.
The primary objective of the fund is long-term capital growth. However, we consider the fund to have a SMid-cap core objective with a “quality at a reasonable price” style. Currently, assets under management are $49 million.
Q: What is your definition of quality?
For us, quality companies are consistently strong financial operators with solid competitive positions and which exhibit less volatility than their peers. We tend to avoid deep cyclicals and turnaround stories; our valuation discipline leads us to avoid paying a higher price for companies with more rapid growth. Typically, the portfolio is core with valuation being quite important.
Additionally, we believe that stocks have an intrinsic value that should be based on a company’s discounted future cash flows, and further, that quality companies have more predictable cash flows. Because market prices often deviate from this estimated intrinsic value, it creates an opportunity for us to buy a stock.
Q: How do you define your investment philosophy?
Our philosophy developed from the belief that quality stocks bought at a reasonable price offer better risk-adjusted returns over the longer-term time horizon that we target. Additionally, by combining fundamental bottom-up research with our proprietary quantitative assessment, we can construct a portfolio that offers a better outcome for our clients.
Importantly, our understanding of the long term is unique: we believe that quality lasts longer than most investors anticipate, and in many cases, it takes time for fair valuation to become realized.
Q: What is your investment process?
Our process combines fundamental research with a quantitative overlay to determine whether a stock is a quality company selling at a reasonable price; we want to find those that trade at a discount to fair value.
We start with the 2,200 to 2,300 stocks that have market capitalization between $300 million and $15 billion. Then, using a proprietary quantitative screen which looks at valuation, quality, momentum, and growth, our investable universe is narrowed down to just the stocks in the top 30%.
During fundamental analysis, an analyst will review a company’s filings and discuss both the company and its industry with management and industry experts, including sell-side analysts and other contacts. After modeling his/her outlook, the analyst presents a research report for discussion. The report summarizes the merits and risks of the recommendation and provides details on the quality evaluation test, a descriptive analysis of the company’s products and competitive position, and a financial statement analysis which includes a valuation based on discounted cash flows (DCFs).
Q: Can you describe your process with a few examples?
Alamo Group, Inc., a manufacturer of agricultural and infrastructure maintenance equipment, has been a winner for us, and is a good example of a smaller, undiscovered company that has been successful in growing its businesses even in a challenging macro environment.
There wasn’t a lot of information readily available about Alamo Group; the stock isn’t widely covered by Wall Street and the company doesn’t give formal earnings guidance. However, it got our attention when it ranked quite highly on our quantitative screen.
We proceeded to study the company’s filings and did some preliminary fundamental research, including a conference call with its management team. We discovered that the company benefited from operating in some unique markets. The infrastructure and maintenance equipment side of Alamo Group’s business is less cyclical than other equipment manufacturer’s because the company sells many of its products – like snow removal trucks and large mowers – to municipalities. On the agricultural side, brands like Bush Hog aren’t as directly tied to foreign demand, but are more of a necessity to manage a farm.
Though Alamo Group was in an industry with a challenging macro environment, the company was delivering good results, showing margin improvement, and had a good acquisition strategy. It’s not unaffected by macroeconomic pressures, but being a smaller company gives it the advantage of having plenty of avenues for growth within its core market.
For larger companies, it’s usually difficult to continue their growth rate; they must continue to do larger deals that are tougher to integrate, or enter new markets that might be more challenging than existing ones.
Just given its smaller size, in Alamo Group we saw a company that still has acquisition opportunities, that still has opportunities to expand its business, and still has opportunities to take market share. About half its growth is through acquisitions and the other half is organic growth, which is a mix we typically like.
Generally, we don’t want companies that only grow by acquisition because they have to be really excellent at executing – and even a company that is excellent at that sometimes misses. So, we prefer businesses with diversified growth channels like Alamo Group.
Q: Would you discuss another example in a different industry?
Valvoline Inc, the provider of motor oil and automotive lubricants, was a recent purchase. Last year, it spun off from Ashland Global Holdings Inc, and now is an independent publicly-traded company.
Selling a wide variety of motor oils remains an important part of Valvoline’s business. It’s a great consumer brand, and the company has successfully increased the mix and complexity of its motor oils to make premium products that have helped margins grow. Another big contribution to returns comes from its Valvoline Instant Oil Change franchises, which offer drive-through oil changes.
Often with spinoffs, restructuring can negatively affect sales growth. However, we think Valvoline’s strong management team will be able to operate more efficiently as an independent company. Moreover, now that it’s no longer a subsidiary, we expect Valvoline will ramp up growth and strategic initiatives. One opportunity we see would be international expansion, as the company is currently underpenetrated outside of the U.S.
Q: Do you set a price target when valuing companies?
Yes, we do. Valuation is an important part of our process of setting price targets. Primarily, we model and value companies by discounted cash flows; secondarily, we consider measures including price to earnings, enterprise value to EBITDA, price to book, and free cash flow yield. While DCF is core to our approach, we recognize that in certain industries another valuation measure might better assess what a price target should be.
While looking at relative and absolute valuations helps us identify potential turning points in the cycle, we don’t attempt to make top-down market timing decisions. Typically, we keep the fund’s cash levels low, and to ensure we set price targets that still allow the fund to be nearly fully invested, we will at times adjust the discount rate of our DCF model.
Q: What is your sell discipline?
We sell a stock when it surpasses our price target as well as for a host of other reasons. For example, we might sell in order to buy a more compelling opportunity with greater upside, or if a company fails to meet our expectations of quality, or we lose confidence in management, or the company’s competitive position is unexpectedly challenged, or if its balance sheet is becoming too risky with leverage.
Regardless, we always use the valuation estimate to continually challenge our original fundamental thesis and ensure it’s still intact.
Q: How do you construct the portfolio?
Our primary focus is on bottom-up security selection. We think about investment themes in the natural flow of our fundamental research and factor in our views as we model cash flows. Top-down themes aren’t applied across the portfolio, although we are careful about how the fund is positioned relative to various macroeconomic outcomes.
We monitor the weightings of our benchmark, the Russell 2500 Index, but don’t actively seek low tracking error. Also, we take time to understand what is driving performance attribution in the SMid-cap space.
Typically, the portfolio has 70 to 90 stocks. The maximum position size for individual holdings is 2%. At the sector and industry levels, the fund has loose constraints but it hasn’t come close to approaching them.
We seek diversification by allocating across all sectors and are careful that the fund isn’t overly concentrated at the industry level. Also, macro factors are examined to ensure the portfolio isn’t highly sensitive to changes in different market styles, and we pay a lot of attention so that our cyclical exposure is not too high.
Q: What risks do you monitor? How do you contain risk in the portfolio?
Risk is managed at both the portfolio and security levels. For us, standard deviation of returns is a primary portfolio risk measure. We aim to maintain volatility that’s lower than the benchmark’s, and through our construction process the portfolio is diversified by sector, industry, and risk factors.
Other risk characteristics are regularly monitored, including the Sharpe Ratio, upside capture, and especially downside capture. As well, we keep an eye on performance attribution characteristics to make sure the portfolio is performing as expected given a particular environment.
At the security level, every stock must pass our fundamental quality test. To us, a significant part of risk management is evaluating a management team to determine whether it’s making smart capital allocation decisions, avoiding aggressive accounting, delivering on strategic goals, operating the business in a way that can withstand recessionary periods, and is successfully reducing competitive pressures.
One of our core beliefs – and a belief where risk can transform into opportunity – is that quality companies are the most likely to survive bear markets. During times when the overall market is in decline, we can get them at a reasonable price. At the same time, finding companies that might be out of favor due to sentiment, but which we believe are still quality companies, also leads to some really good bargains.
