Portfolio management and analysis in 5 minutes

Preserve your capital, then make money

After my first semester of college, I was offered a position as a Junior Portfolio Manager for an asset management firm whose capital totaled ~$200 million and assisted with research analysis for another firm whose capital totaled ~$1.3 billion. The story of how I landed, or rather hustled my way into, this job is for another day. Instead, I want to share the invaluable knowledge about valuing corporate credits/equities, building portfolios, and managing risk that everyone should know before investing a dime into the stock market. This article serves as a condensed introduction to the philosophy behind good investors.

Objective credit research is imperative for bond/stock selection and risk management.

Understanding how to build and maintain portfolios around fixed income/credit analysis and equity valuation will empower you to make security selection decisions based on objective data and analysis. First, understand the reasoning behind researching and ranking the credit and equity of bond/stocks to form valuation reports.

Corporate Credit Ranking

Beneficial for the construction and maintenance of corporate fixed income portfolios.

Equity Valuation Ranking

Useful in identifying equity securities with superior credit quality, equity “cheapness” or any combination of credit quality and equity appeal.

Comprehensive Valuation Reports

Include relative value analysis between bond yields and equity return, a decomposition of equity returns between yield and expected growth, as well as a detailed review of expected stock price ranges based on historical and relative value characteristics.

Investment Process is derived from your Investment Philosophy

Market participants increasingly rely on managed assets (ETF’s, Individual Account Managers) for portfolio selection, and as a result asset allocation has superseded individual security selection.

For those investors still interested in security selection, sell-side research, national credit rating agencies, and other third-party research sources have often been deemed unreliable, biased, and self-serving.

Since investment returns are a function of price paid, income earned, and sale price achieved, all three are relevant inputs in identifying an asset’s total return potential on an absolute basis, relative to its peers, other securities from the same balance sheet, as well as the overall market expectations for fixed income and equity returns.

Investment Methodology

Bridges the gap between fixed income and equity security analysis to ensure that investment (whether investing in debt or equities) expected return is consummate with the risk associated of owning that specific security. The expected return on an equity security is compared against the yield on a company’s debt, the earnings yield of the overall market, including adjustments for the uncertainty of the company’s future earnings power.

Fixed Income. When managing fixed income assets, outperformance is generated primarily by avoiding deteriorating credits, rather than trying to guess future changes in the yield curve or market timing fixed income exposure.

Equities. The methodology for equities is an extension of fixed income analysis. View equities as the residual claim on a company’s assets following debt claims and other senior securities.

Fixed Income / Credit Analysis

Overlay a disciplined ranking strategy of fixed income securities to identify the issuers that have superior liquidity profile, improving credit performance, and a strong capitalization that can withstand external shocks better than their peers.

The process doesn’t rely on credit ratings provided by credit rating agencies (such as Moody’s and S&P) but can be used within any rating category to identify better capitalized and improving credits thus helping avoid issuers with deteriorating fundamentals. When managing fixed income assets, out-performance is generated primarily by avoiding deteriorating credits — rather than trying to guess future changes in the yield curve or market timing fixed income exposure.

Fixed income securities ranking process. Measure performance/credit metrics for each issuer based on publicly filed financial statements (update quarterly). Grouped these metrics into four broad measurement categories (in order of importance to the methodology):

Liquidity Metrics Analysis — measures ability to withstand external shocks

Fundamental Trend Analysis — directional analysis through the business cycle

Enterprise Value/Asset Coverage — measures debt coverage as a function of balance sheet and capitalization

Cash Flow & Credit Quality — an analysis of EBITDA-driven free cash flow computation versus Statement of Cash Flows-driven free cash flow computation as well proprietary risk analysis, partially driven by the Altman-Z Score (a default risk tool).

Treat the banking sector and bank stocks differently, due to their unique business models that over-emphasize accrual accounting. As a result, the metrics are somewhat different than corporate metrics, but generally fall in the same categories. Furthermore, a bank credit and equity rankings are unique to the banking sector. For example, a 70% credit score for a bank implies only that it ranks higher than 70% of the bank universe, not the entire coverage universe.

Credit rankings (100% representing the best capitalized companies, 10% the worst) can be used for portfolio construction to limit reliance on credit rating agency ratings, or within rating agency ratings categories to favor better capitalized companies. Furthermore, rankings show four sub-categories within credit rankings, thus users can decide to favor certain elements of credit strength, or at least gain insight on what drives a specific company’s overall credit rank.

Do credit rankings work? Grouping companies in the corporate coverage universe in ranking categories of 10 percentiles of ranking increment, has consistently shown an R Squared to actual Spread to Treasury of 90% to 98%.

Equity Valuation

Equities. The investment methodology for equities is an extension of the fixed income analysis. View equities as the residual claim on a company’s assets following debt claims and other senior securities. As a result, the trading level of a company’s debt is relevant to establishing a required rate of return for its equity.

Use a dynamic model that incorporates the S&P 500’s earnings yield as it compares to investment grade bond yields. Compare these broad market measures to the fundamental earnings and free cash flow potential of the equities you analyze to establish investment horizon return potential. Finally, a stock’s historic valuation is relevant in establishing expected valuation ranges and your intrinsic value estimation.

Equity analysis tools rely on the following, well-established financial theorems, all of which should be incorporated in your analysis:

1. Firm value is consistent, despite changes of mix between equity and debt capitalization (Miller & Modigliani)

2. The capital asset pricing model (CAPM) can assist in estimating required equity returns based on expectations for the broader marker return and company systematic risk (beta)

3. Low market cap/low price-to-book stocks tend to outperform large cap/high price-to-book stocks even once adjusting for beta (Fama & French)

4. Companies that combine a high earnings yield (inverse of P/E) and high return on invested assets and tend to outperform (Greenblatt).

As always, I thank you for your interest and support, and welcome any questions or suggestions.