Q: What is the history of the fund?
The Nuance Mid Cap Value Fund was launched on December 31, 2013, by Nuance Investments based in Kansas City, MO and founded in 2008 by Scott Moore. The company has a classic, value investment philosophy focused on three primary strategies: Mid Cap Value, Concentrated Value, and Concentrated Value Long-Short.
Q: How is the fund different from its peers?
We are intently focused and judge ourselves on our risk-adjusted returns over full economic cycles. So, we basically use the Sharpe Ratio, which is a measure of the average return minus the risk-free return divided by the standard deviation of return over an extended period to evaluate our performance.
In addition, we run a concentrated portfolio that has between 50 and 90 positions at any one time. Most of our Morningstar peers run between 100 and 150 names, some as many as 200, in their portfolios. We also employ a very nimble portfolio management style.
Q: What core tenets drive your investment philosophy?
Our investment philosophy is based on a disciplined approach to value investing where we review in detail one company at a time. Our goal is to offer better than average returns with below average risk.
In general, we focus on identifying and investing in what we believe to be leading businesses that are temporarily or transitorily underearning their long-term potential. When companies are underearning, they generally offer an attractive risk-reward opportunity from a valuation perspective. If we purchase them at the right price, we believe our portfolio will generate leading risk-adjusted returns over time.
Q: How does your philosophy translate into the investment process?
Our investment process starts by first finding businesses that are the number one or two in market share, have very stable competitive positions, and highly visible futures. The companies must also exhibit better than average balance sheets and exhibited better than average capital allocation decisions over time.
To find these businesses, we use a quantitative screening process covering operational data on thousands of companies over a period of 15 to 30 years. We focus on companies that we believe have higher than average returns on capital, lower than average volatility of returns on capital, better than average balance sheets, and capital allocation over time. That reduces the number of companies of interest down from thousands to the hundreds.
Next, we undertake a competitive analysis to determine the competitive positions of each one of these companies and evaluate if they are leaders within their markets. Here we are looking for two things: leadership and visible futures.
The third step is performing a financial statement analysis by generating a normalized income statement, balance sheet and cash flow statements. We look at potential transitory and cyclical events and come up with what we consider a normal or mid-cycle earnings per share calculation for each company.
Some of the larger items we normalize include tangible asset turnover, margins, tax rate, interest rate, capital spending, and balance sheet leverage. That helps us determine the normal earnings per share calculation. Our estimates don’t necessarily match what they are earning today or what the Street is predicting, but this is our proprietary earnings per share calculation
The fourth step is our valuation study where we project two very distinct price targets. The first uses our normalized earnings per share estimate along with a variety of metrics to calculate a fair value price target. The second price target is the downside price target which reflecting various risk factors. We update these price targets quarterly.
The fifth step of the process is our portfolio construction. Here we optimize the risk-reward at the portfolio level each and every day. We have a universal spreadsheet where all the price targets, earnings powers, and other relevant data for our 250 industry-leading companies are displayed. This allows us to see in real-time, the risk-reward for each security and the impact it has on the portfolio.
So those are our five steps of the investment process and it helps us identify where the potential opportunities are in the marketplace. We spend time every morning trying to optimize the risk and reward ratio of the portfolio for our clients.
Q: Can you give an example to illustrate your process?
BOK Financial Corporation, also known as Bank of Oklahoma, is a financial services provider we have in our portfolio. It is the leading commercial lender in the State of Oklahoma with about 15% market share and has steadily grown its market share. It holds a sizable portfolio of fee-generating businesses that has produced an attractive return on capital over time. BOK Financial is a company that fits well within our investment criteria.
In 2015, BOK Financial was trading around $75.00 and our estimated fair value was roughly $80.00 with a downside of $40.00. The stock’s normalized earnings per share were around $5.50 per share; however, their actual earnings in 2015 were around $4.50. Because low interest rates had compressed their net interest margin to unsustainable low levels, the stock was out of favor.
In early 2016 the price fell to the mid-40s. Because our estimated fair value was $80.00 and our downside price target was $40.00, we added aggressively to our position in the first quarter of last year. As the year progressed, interest rate increased and BOK’s earning power went from $4.50 to $5.50. The price recovered from $45.00 to north of $80.00 by the end of last year, it was our best performer.
Q: Can you cite another example in a different industry?
Another company in our portfolio was the H.B. Fuller Company, the number two global adhesives company. Their global market share is somewhere between 10% and 15% depending on the product line. As a market leader who has been consistently gaining market share, had a reasonable balance sheet and capital allocation policies, H.B. Fuller met our basic competitive position criteria.
After undertaking detailed research into the company, we estimated that their normalized earnings power was around $3.00 per share. But in 2015, H.B. Fuller faced three transitory issues; a raw material squeeze, a botched SAP implementation, and an acquisition that did not integrate as expected. As a result, their earnings per share dropped from $2.50 to $2.00 after which the stock drifted down from $50.00 to as low as $33.00 in the first part of 2016.
Our estimated fair value was around $50.00 with a downside price target of $25.00. As the stock went down, the risk-reward became more attractive and we felt pretty confident that the earnings issues they were facing were transitory in nature. We started buying and by early 2016 the name was a significant part of our portfolio.
Over the course of 2016, the company’s transitory issues were resolved and earnings rebounded to $3.00. The price went up from the low $30.00s to the low $50.00s where it is today.
Q: How is your portfolio constructed? Is diversification part of your portfolio construction process?
Our target range is between 50 and 90 names in the portfolio, but it generally averages between 50 and 60. Diversification is not the major driver in our portfolio strategy. Instead, the process is based on our fundamental research into each security and an assessment of their fair market value and downside price target.
In evaluating each of our potential securities, we also assign a peak weight that reflects our certainty of the company’s degree of future visibility. We are willing to take larger positions in companies that we view as having higher levels of certainty. So, generally speaking, the max position of any one name in the portfolio is 7.5% and the minimum is 0.5%.
Our portfolio construction is driven by an assessment of risk and reward at the security level. But we also do have sector, industry, and diversification constraints that we overlay on top of our risk-reward and peak weights when we configure the portfolio.
Q: How do you define and control risk?
We define risk in terms of the standard deviation of returns, so we view the world from the perspective of a Sharpe ratio. In an attempt to control our overall portfolio risk, we aim to control the risk associated with each of our stocks. Every day, we calculate how much downside potential exists in each one of our stocks and in our portfolio.
We make sure that each company has a sound competitive position and we monitor their balance sheets to make sure they haven’t taken on additional financial risk. We also dig into their capital allocation priorities to make sure they are not diluting our price targets. This detailed monitoring gives us confidence that our downside price estimates are still on target.
