Q: What is the history of the fund? 

The Wells Fargo Advantage Special Mid Cap Value Fund is managed by a pair of CPAs who came together in 2009 to leverage their unique backgrounds in an effort to exploit inefficiencies in the equity market. 

The formation of the portfolio team reflected the merger of the Wells Fargo Advantage and Evergreen Fund families. In the middle of the economic downturn, Wells Fargo acquired Wachovia, which owned Evergreen Investments. Thus, when Wells Fargo and Wachovia merged, Jim and Bryant merged too. 

Since we had managed our separate small and mid cap value portfolios with a very similar philosophy and process, joining our teams together proved a logical extension. Talking about similarities, a distinguishing factor in our team is the unique background that we share. We both started our careers as accountants and decided to transition ourselves into the investment world. Coming into the investment world as accountants has a major influence on our stock selection and portfolio construction processes. 

While being a CPA does not necessarily make one a great investor, it certainly contributes with the added value of an analytical approach that is more skeptical and rigorous in nature. Not only do we benefit from this skepticism, but we also strive to infuse it into our analysts so that they are as questioning as we are when looking at the numbers. This ability to scrutinize allows us to uncover value in areas that may not be so obvious to investors, and our analysts have been trained to spot those areas too. 

Q: What is your investment philosophy? 

Our philosophy hinges on the idea that the market is relatively efficient in many ways and inefficient in just a few. Hence, our job as investment managers is to try and exploit any inefficiency that might exist in the marketplace. We have identified three key ways in which we can do that—two key ways and one key process, in particular, which help us on a regular basis.

The biggest inefficiency, as we see it, is how other investors tend to ignore balance sheets. In fact, in their evaluation of companies, most investors are heavily focused on the income statement, relying on a backward-looking financial statement to extrapolate future results. Consequently, the market is very efficient at adjusting stock prices once information is displayed on the income statement. 

For some reason analysts, investors, portfolio managers, are either unwilling or unable to properly analyze a balance sheet, or in other words, the company’s current capital structure, and compare it to what that capital structure should be if the company were to optimize their potential. What we do is focus on the balance sheet to understand current capital structure versus the optimized capital structure, and then quantify that gap to determine how the company will allocate that capital and the value they will create in the future by doing so. That balance sheet focus is a huge differentiator for us.

We also focus on free cash flow. Here, the inefficiency exists because investors tend to take shortcuts by using GAAP-based earnings as a proxy for free cash flow. Every investor knows that the value of a business is based on the free cash flow the company generates into the future. 

With the help of our accounting background, we spend considerable time recasting the financials from a GAAP-based earnings number to a true free cash flow number, looking at all the different assumptions and estimates that go into the GAAP-based number and then all the off-balance sheet elements that will determine the future free cash flow.

Q: How would you describe your investment process? 

Our process is based on capturing companies that have three key criteria. The first decisive factor we want to see in all our companies is a unique competitive advantage. As we model our companies out three to five years, or even longer, we know that a competitive advantage provided by a durable asset base will help the economics of that business last long into the future. 

The second component of this set of criteria is strong, sustainable free cash flow. We will not typically invest in companies with a high degree of cyclicality to their business models. However, as value investors we find ourselves buying companies when the sustainability of free cash flow is being questioned by other investors. 

Finally, we insist on seeing a flexible balance sheet. The market typically undervalues the value-creating potential of the balance sheet, so we are looking for a balance sheet that is available to be deployed in order to create value. 

Q: What is your definition of mid cap? 

Although the index range is somewhat wider, for us the mid-cap range is between $2 billion to $20 billion at purchase price and we will allow our stocks to grow to around $30 billion. For example, we have owned Allstate Corp when it was a $12 billion company and today it is close to $30 billion. The mid-cap space includes between 500 and 600 companies, but we do not follow all of them. Given the depth of work we do with each portfolio candidate, we reduce the number of potential holdings to about 250 stocks that we follow. 

Q:  Would you elaborate on your research process? 

The process begins with a qualitative assessment of competitive advantages encompassing the popularity of a company with customers, the demand for its products and services, the quality of the supply chain and the management team. We are also looking for continuity between how management and how we are incentivized, which is stock price appreciation. We complement this qualitative work with the financial statement analysis. Beginning with how safe the company’s balance sheet is, we want to see margins of safety in a bad environment. 

Our process is often compared to that of a bond investor. A lot of the CFOs we speak to may think that we are actually interested in the credit side, when in fact we are interested in the equity side. That is simply because we are eager to understand why they choose certain types of debt, how much debt is reasonable for their company’s cash flow statement and for their fixed asset base, and what the covenant structure or the maturity profile of their balance sheets are like. 

From there we go on to assess the degree to which this company can deploy their capital to create future value. There are very few things that CEOs and CFOs can control on a daily basis, but what they always control is how they would use their capital structure to create shareholder value. We focus on how much capital they have to deploy, how they are going to deploy it, and what kind of value they will create by doing so. This approach gives us some sense of our management teams controlling their own destiny. 

Then, we go into the free cash flow, starting from an earnings-based number to a free cash-flow-based number, and we compare how free cash flow can differ from GAAP-based earnings to find that sustainable free cash flow power of the business.

At this stage we walk away with a clear understanding of whether the company has all three of our key criteria, but we still do not know the valuations and what we should pay for the company at this point in time. As value investors, we are almost always buying companies in times of distress, something that usually creates a perceived impact on the sustainable free cash flow. Our job is to analyze the company together with the current situation that is causing the company’s trouble, and determine whether it is temporary, what it will cost to fix, and how long it might take to fix it.

When looking at a company, we see an opportunity typically from a valuation standpoint because we have a differentiated opinion as to the magnitude of the issue, its duration and how that impacts free cash flow. When we think about valuation, we look out three-to-five years to determine the long-term free cash flow outlook once the temporary issue has been solved.

When we add together our long-term free cash flow projection, the balance sheet analysis and any off-balance sheet opportunities, such as tax assets or real estate, we arrive at our price targets. One of the key differentiators for us is that we do not just stop with an upside price target. Unlike most investors, who spend a lot of their time chasing upside, we do not ask how much we can make by owning a company but we ask ourselves if we are being properly paid for taking on the risk of owning this company. In order to answer that question we need to understand the risk of being wrong.

We go through the exact same valuation discipline but we do it by raising questions in a downside scenario. If the temporary issue does not get fixed in three years, but it becomes a more pervasive issue for the company, where does free cash flow go? Instead of the company’s balance sheet being used to create value, what if it was actually used in a bad acquisition and destroyed value? One of the key tenets of our philosophy is protecting capital in down markets, and having a strong balance sheet is key to protecting capital. 

For every company we have two price targets—an upside price target and a downside price target. In this way we can create a ratio—an upside potential versus downside risk from the current stock price. We use that ratio to decide whether to buy the stock, how big the stock should be in our portfolio, and when we should trim it back or ultimately sell it. One of the things the team takes great pride in is the consistency in this well-defined approach to valuation and decision making based on the reward/risk ratio.

Q: Would you share some examples to highlight your research process? 

Molson Coors is a company that you would typically find on our coverage list, meaning it has a unique competitive advantage. There are not many global brewing and beverage companies in the world, so they inherently have a unique competitive advantage through their brands and distribution networks. Molson Coors is a consumer staple company that provides very stable free cash flows. 

We were able to buy the stock in 2012 because the market was beginning to question the use of the balance sheet and the stability of that free cash flow. There was a concern about the wine industry and the craft brewing industry taking share from what has been the typical light beer mass market. The trend was affecting revenues and volumes in a marginal way, but there was also a consumer spending slowdown with the recession still playing a part.

With revenues falling modestly and demand slowing because of the shift to wines and craft beers, there was a little bit of a hiccup in the earnings numbers. More importantly, before we bought the stock the company deployed their balance sheet to a relatively large acquisition in central Europe, which depleted some of the balance sheet. At a time when the market was expecting them to continue increasing their dividend and buying back stock, investors did not like the fact that they had spent a couple billion dollars on an acquisition.

One of the beliefs we had was that investors thought the balance sheet was now stretched. When that happens, the market is quick to penalize the stock. However, after concluding our balance sheet work, we became very comfortable that the balance sheet was not stretched but actually had great flexibility to it. 

We bought the stock under that premise at a valuation that was approaching a three-to-one reward/risk ratio, which is an incredibly attractive reward/risk ratio for a consumer staples company of this size. Over our holding period, the company generated material free cash flow, the acquisition proved to be very smart, the company’s cash flow and earnings remained pretty stable, and the stock started to bounce back through 2013 and 2014. The stock has appreciated nicely to a point where the situation is different today, but the market still undervalues it and the current stock price does not reflect the value the balance sheet can create in the next two to three years. 

Another example would be DST Systems, a provider of technology and services that make up part of the backbone of the financial services and healthcare sectors. The financial services segment at DST was under pressure for a couple of years due to industry-wide changes that negatively affected the company’s revenue potential. Essentially, that created a headwind for organic revenue growth. The market hates hiccups like this, especially if a hiccup lasts more than 12 months. 

When we looked at the business we saw a very strong competitive advantage and a solid market share, but the company was just not growing in line with market expectations. We concluded that the negative industry-wide change was about to come to an end and they were going to begin growing their market share. What is more, the old management team at the time of the stock purchase had spent the previous two decades investing the free cash flow into non-operating assets, whose worth was not visible enough to the market. Overall, we had a good degree of confidence that the free cash flow and revenue would start to inflect again and the balance sheet value was large and under-appreciated. During our holding period we have seen the industry-wide headwind abate while organic growth has now picked up into the low single digits. The new management team is monetizing the balance sheet and giving the proceeds back to investors through large and consistent buybacks. That is all we need for our stocks.

Q: What is your buy/sell discipline? 

More often than not, the sale decisions are driven by valuation. For instance, if the stock had a three-to-one reward/risk ratio at the time of purchase, it might be in the top third of our portfolio in terms of its weight in the portfolio. As the market appreciates its value, the stock price moves higher and, mathematically speaking, the reward/risk ratio will go from three-to-one down to a two-to-one. 

The process dictates that as the stock goes from a three-to-one to a two-to-one, it is no longer as attractive and we should trim the name down on our portfolio. If the stock should underperform from there, it would go back to a two-and-a-half-to-one and we could add it back to our portfolio. We use this reward/risk ratio to systematically optimize the portfolio over time and in order to maintain consistency in our results. 

At the end of every quarter, we look at how the portfolio has performed over the last 12 months. The calculation reflects all of our decision making (new names added, trims, adds, etc.) over the period compared to what the portfolio would have done had we accepted the portfolio that we owned 12 months ago and done nothing (i.e., buy and hold portfolio). Through this analysis we know that in all but one 12-month period on a rolling quarterly basis our actual portfolio performance has outperformed the buy-and-hold portfolio. This tells us that the aggregate value of our decision making is consistently adding value. It is our belief that our ability to be consistent is based on the unwavering discipline in using the reward/risk ratio to drive all decisions. The process, by design, mitigates the negative impacts of human behavior on investment results. 

Q: How do you construct the portfolio and what is the benchmark that you use? 

The benchmark for the fund is the Russell Mid Cap Value Index. The average number of names is about 60 stocks and we do not target any specific turnover. Our name turnover is about 35% and our overall turnover in the portfolio is around 55% to 65%.

We cap our individual position sizes at 3% at cost and 5% at market, while our sector weights are the function of bottom-up analysis. We do not discuss from a top-down perspective whether it is time to go overweight in healthcare or underweight in industrials; all of our sector weights are simply a function of more ideas within one sector flowing to the top of our watch list, becoming more attractive and we buy them as part of the process.

We need to be aware that there is correlation risk. In the event you are wrong and many of your holdings are exposed to the same dynamic, you leave the portfolio susceptible to one mistake causing the portfolio in total to be destroyed. To prevent this, we cap our sector weights at 25% of our portfolio in any one sector, except for the financial sector where the benchmark is typically in the low 30%. We are allowed to go up to 500 basis points over the benchmark weight in the sector if the benchmark is above 25%.

We constantly test our investment thesis for all of our companies. If we are wrong in terms of timing, or if we are wrong on valuation and we overpaid by a little bit, we will reflect that in our portfolio weights and we will adjust as necessary, but we will not just sell the stock due to a timing issue.

Q: How do you define risk and what do you do to mitigate it? 

We think of risk at two levels – company risk and portfolio risk. Our entire process from a bottom-up stock selection standpoint is based on quantifying, mitigating, and understanding risk. By having companies that generate sustainable free cash flows, the first thing we do is that we immediately up the quality of our names and reduce the risk profile, respectively.

When we have stocks that are highly cash generative, that have low maintenance capital spending, that have the availability to access the credit markets at very attractive rates, and that have a level of EPS predictability well above average, then we can find names that fit that bill. Conversely, when we accept companies that are highly capital intensive or that have end markets where they have no control over pricing and they can be highly variable, there is less likelihood of success. 

Not only do we create upside potential as our company’s strong balance sheet value is recognized, but we also establish a floor in our stocks. We want all of our companies to be in a position to act offensively when the market around them is being defensive. In times of crisis when stocks are being sold off and demand for industry products and services are declining, we want our companies to be the stable ones in their group that are still aggressively pursuing market share or using their balance sheet to buy back their own stock at very discounted prices. That ability to be offensive when the world around is being defensive is a common feature in all of our companies and one that helps mitigate risk at the portfolio level.

We want to allow our performance to be driven heavily by stock selection. We do not want correlations, themes or any other characteristics, such as market cap or style factors, to drive performance. We have the tools in place to understand every decision we make and how it consequently impacts both intended and unintended risks.