U.S. Equity Capital Reinvestment
Seeks superior total and risk-adjusted returns by investing in companies that reinvest in their business to grow free cash flow.
At a Glance
Our U.S. Equity Capital Reinvestment strategy focuses on companies that reinvest in their businesses to grow free cash flow. We seek companies that are good capital allocators, and that use capital effectively to fund internal projects or to make acquisitions. Our research indicates that companies that make investments, internally or externally, that generate a marginal return on invested capital that exceeds their marginal cost of capital will increase in value. The U.S. Equity Capital Reinvestment strategy pursues attractive total returns by investing in a diversified portfolio of these companies with persistent, high return on invested capital (ROIC) which is achieved through their allocation to the growth-oriented uses of free cash flow, namely investment in internal projects and acquisitions. The portfolio generally holds between 75 and 120 stocks from equity markets worldwide, with risk controls to diversify the sources of growth and reduce volatility.
The U.S. Equity Capital Reinvestment Opportunity
- Access to a portfolio of high-quality global companies with attractive capital appreciation potential
- Portfolio holdings generate strong free cash flow and use their cash to reinvest in their business through internal projects and acquisitions
- Invests in companies with a persistently high spread between ROIC and weighted average cost of capital (WACC)
- Active management by an investment team with an average of over 20 years’ experience
- Risk management integrated with the investment process
Epoch’s Distinct Investment Philosophy and Approach
Epoch believes that the key to understanding a company requires a focus on the cash generation drivers of the business — not a focus on accounting terms like earnings or book value. How does the business generate its free cash flow, and how does management allocate that cash for the betterment of the owners of the business; i.e., the shareholders? It is the ability to generate free cash flow that makes a business worth anything to begin with, and it is the ability of management to allocate that cash flow properly that determines whether the value of the business rises or falls. There are only five things that management can do with a company’s free cash flow: pay a cash dividend, buy back stock, pay down debt, make an acquisition, or invest in internal projects. If a company can invest, either internally or in an acquisition, and generate a marginal return on invested capital that is greater than its marginal cost of capital, then making that investment will increase the value of the business. But if the return is going to be less than the cost of capital, making the investment reduces the value of the business, and management should return the capital to the shareholders. Accrual-based accounting measures such as earnings, and valuation metrics based on earnings, simply do not provide the relevant information as to whether a company is successfully generating free cash flow and whether management is allocating that cash flow properly. This strategy uses proprietary quantitative research to identify potential investments. We look for factors including ROIC greater than WACC, growth in cash flow from operations over the last five years, expected revenue growth greater than expected global GDP growth and high or expanding margins. Stocks are then subject to rigorous fundamental research which is designed to assess the sustainability of the competitive advantages that has enabled each company to achieve its level of ROIC. Risk management is integrated throughout the process with a focus on avoiding unintended risks. Portfolio risk exposures are monitored and formally communicated to portfolio managers on a regular basis and are discussed at investment meetings. The team performs a portfolio rebalance on a quarterly basis that incorporates the results of a risk optimization analysis as well as the latest results of the quantitative screens. Positions can also be added or removed at any time based on input from our fundamental analysts or in reaction to new information. There are no absolute or bench-mark relative sector or regional constraints. The maximum premium on WACC contribution per security is 3.0% so that the portfolio’s aggregate ROIC – WACC is not dependent on any single security. Additional risk measures include maximum contributions to cash flow growth per security, revenue growth per security and cash flow margin per security. Position size is generally 0.25% to 2.0% and determined by the portfolio managers with input from the analyst and our Quantitative Research and Risk Management Team. Position weights are inversely related to the risk presented by the security within the context of the overall portfolio. Stocks are generally held as long as they continue to display the sustainable growth characteristics we seek, specifically ROIC well above WACC. Stocks are reduced or sold if a company’s fundamentals change, there are more attractive alternatives with a better risk-reward outcome or if there is deterioration in the investment criteria.
The dispute between the U.S. and China is clearly not just about trade, or even technology. At stake are the values that will determine the architecture and governance of the global world order.
Cold War 2.0: The Platform, the Players, and the Stakes
The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fueled a surge in IPO listings and produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals. The big question is, are we repeating the excesses of the dot-com boom? In this paper, we look at the reasoning used by those who think history is repeating itself including IPO supply, profitability and VC funding. We also look at the weaknesses in those arguments and why some believe that the current situation is different from the dot com bubble, such as median age of tech IPOs and sales growth. Finally, we explore how investors can look at these companies through a free cash flow lens.
Blitzscale and Hope: Unicorns, IPOs and the Fear of Repeating the Late 1990s
Does a stock’s price and its P/E ratio tell you how much a company is worth? Conventional wisdom says yes, but we think otherwise. In this paper we explore:
- The theory behind the discounted cash flow (DCF) valuation model and the underappreciated role that ROIC plays in the model
- The P/E ratio and find that it does not tell us what most people think it does, nor does its offshoot, the P/E to growth (PEG) ratio
- How we can use what we have learned about the DCF model to deconstruct P/E ratios in the real world to better understand what they do tell us
The P/E Ratio: A User’s Manual
If there is a “small-cap effect” then why has the Russell 2000 underperformed the Russell 1000 over time?
The Size Paradox
China’s mercantilist behavior, underscored by its “Made in China 2025 initiative,” is in conflict with U.S. demands for greater IP protection, a level playing field and improved market access. Left unresolved, free trade and globalization will be in retreat, with broad economic implications beginning with manufacturers.
Trump, Tech and Trade
While the e-Commerce index as a whole appears frothy, many companies in the sector do possess sound and promising business models. For investors, the key to success is understanding how these business models should be valued. In this paper we examine the reasons e-Commerce may be a bubble, the reasons it may not and a free cash flow based methodology for valuing e-Commerce companies.
Is e-Commerce a Bubble?
Three developments (the unwinding of QE, the soaring US budget deficit and the impending wall of maturities, especially of corporate bonds) will engender higher volatility and wider credit spreads. There is also a risk that interest rates will start rising for “bad” reasons (that is, an increase in fixed income supply). Each of these outcomes would be a headwind for high duration strategies.
The Return of Price Discovery
Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Our new white paper explores the limits of MPT in aiding successful investing.