Investment Strategy Statement - CashFlow Hunter

by: CashFlow Hunter
Summary

This article describes my general approach to investments regardless of security type.

My view across capital structures heavily influences my investments.

My experience first as a sell side HY bond trader and then on the buy side in both hedge funds and mutual funds gives me broad understanding of different stakeholders.

I currently manage a series of mutual funds with different mandates but each has the same core approach of sensitivity to valuation, capital structure and cash flow generation of target investments. I attended an undergraduate business school and received also my MBA after working for four years. I am a conservative investor. I am very conscious of risk. My biggest influences are Warren Buffett and Carl Icahn. I have been an active investor since 1995 with experience at a major bank trading desk where I traded credit derivatives (CDS) and bonds for low investment grade and high yield companies. I was the first employee for a multi-strategy, credit hedge fund where I ran a long/short portfolio of bonds and equities. I now manage a long/short income mutual fund as well as a long-only value fund and a long-only growth fund. I have invested in almost every security type up and down corporate capital structures from equity options to bank loans, always looking for the security long or short that will give the biggest bang given the risk. My investments are almost always individual securities rather than indexes. I usually avoid major macro market calls and I usually do not trade commodities although some of my investments can be partially driven by macro events or commodity prices.

Investment Strategy

My focus on the long side is finding undervalued securities where the market misunderstands a company's cash flows/capital structure and/or growth prospects. My focus on the short side is finding companies with secular or deep-cyclical problems that the market is ignoring with a catalyst that will bring those problems to the fore. I avoid "valuation shorts" which just involves shorting something because it is overvalued but there is no negative catalyst. I usually trade only in US or Canadian companies and I usually avoid microcaps (smaller than $250-5000mm).

Security Types

I am agnostic about security type I invest in. I am comfortable investing in stocks, options, bonds, preferreds etc. My favorite investment hunting ground is companies with large, complicated capital structures as that presents both opportunity for market mispricings and plays into my skill sets best. I love finding long investments where the market is not analyzing credit correctly. Conversely, it can be difficult shorting bonds as a retail investor but there is no better risk/reward than shorting a bond above par of a company you expect to run into trouble.

Investment Process

I model every investment, using 10-Q's and 10-K's. I usually read several years worth of 10-K's so my models usually have at least 5 years of results (prefer longer) with the most recent 2-3 years broken down quarterly. I am always looking for a company's ability to generate cash...throughout economic cycles. I also look at a company's use of cash be it dividends, buybacks and cap ex. I like to look at cash return on tangible assets and invested capital and return on equity to a lesser extent. I usually want to see at least double digit returns on tangible assets and invested capital. Companies that are serial acquirers usually trigger my warning antennas as do companies that always have to raise capital to fund growth. The reasons I find those two things concerning is constant acquisitions make it difficult to understand organic growth and profitability and not self-funding growth means a market hiccup can lead to a cash squeeze.

I never use street research to tell me what a security is worth. I can figure that out myself. I only use street research to highlight a fact or industry development I might have missed.

I compose articles on names that I have the highest conviction on. I don't write just to get my name out there or gain followers. If you read the my articles you'll find I focus most on valuation, capital structure and cash flow generation. Two of the companies I have written about have been acquired in the past two years and one of the companies I wrote as a short dropped over 30%.

What I Look For

On the long side in equities I want to invest in a company that grows its worth via cash flow generation or growth in value of a key asset (which usually throws off cash). I don't really care whether they pay out that growth in the form of dividends or buybacks provided the buybacks are being made at a reasonable cash on cash return (hopefully at least high single digit) or similarly at a significant discount to book value. I also look for management teams that show long term discipline with capital allocation, compensation linked to cash generation and growth and heavy inside ownership.

On the long side in debt, I'm looking for attractive yield with manageable, quantifiable risks. With debt investing, your upside is capped so you had better understand what you're getting paid and what can happen in a downside (bankruptcy situation).

On the short side I look for overleveraged situations where the sins of the past are coming home to roost in some defined time frame. I don't care if I short a company's stock or bonds. As noted above, the best shorts are bonds trading above par for a company that is about to nosedive. Bond math means the bond can't go too much against you and there is downside to zero.

Approach to Valuation

I am very valuation sensitive. If I'm long an equity, I want to buy at close to if not exceeding double digit free cash flow yields. If it's a balance sheet play, I want to buy at least a 15% discount to book value, which if an investment normalizes to book value means a double digit return. I also like to get paid while I wait so dividend yields exceeding 5% while I wait for valuation to improve is a sweet spot for me.

I do not short just because something is overvalued. It has to be overvalued AND have a catalyst that will make the market determine the overvaluation isn't justified. Overvalued growth stocks can become even more overvalued as long as growth persists.

Approach to Risk

Warren Buffett's first rule is "Don't lose money" and his second rule is "Don't forget rule #1". I HATE losing money. That doesn't mean I shy away completely from higher volatility situations like shipping, but if I do invest I usually invest in calls. For cash securities like common stock, preferred shares or bonds, if you focus on cash flow and balance sheets and are careful about valuation when you invest, you are managing risk to a large extent. If you do not care about market volatility, you do not have to care to much about hedging. For the low volatility income fund I manage, even though we are extremely careful about our longs, we run a low net exposure portfolio precisely because we want to mitigate market volatility. That approach helped us have a deminimus loss last year. But even our long-only funds vastly outperformed their benchmarks in the market drawdown because of our valuation-conscious approach. We will expect to underperform markets slightly if valuation for large index components completely goes out the window and outperform when valuation matters more. Regardless of your timeframe and tolerance for risk, you have to monitor developments and keep your models updated. You won't get every situation right and if things change for the negative, sell your position (or cover if short).

What I Think My Edge Is

I find that the majority of investors are comfortable in either debt or equity. I don't find many investors who are as comfortable as I am investing up and down a capital structure. I think that comfort and my oversight of all a company's securities gives me an edge at picking out the best risk/reward places to invest. I frequently find myself attracted to a company's business but investing in a preferred or a bond rather than the common stock because the risk/reward is better. Again, I'm agnostic at least for our income fund. If you look carefully at how Buffett and Icahn invest, they invest in debt and equity. Again, it's all about the risk/reward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.