A successful investment advisor told each of us early in our career to “never take a shot on the beak, so you can come out for the next round.” It was great advice then and still is today.

We appreciate this opportunity to share the fund management approach that we’ve developed over the past 19 years at RBC Global Asset Management, drawing on lessons learned in previous years at RBC Capital Markets and through many hours studying the habits of successful money managers. Ours is an iterative process that begins with unbiased screening, follows with our own research and analysis, and culminates in ongoing active management of the funds under our care. The touchstone of our process is a commitment to understanding a wide variety of outcomes for the stocks we follow and avoiding attachment to any single forecast. We believe this approach helps in handicapping the odds available in each investment and in building a collection of favourable risk/reward trade-offs that will deliver good results over time. And we invest our money along with our unitholders; the lion’s share of our personal equity holdings is invested in the funds under our care.

The checklist

Every stock market investor needs a checklist as a way of narrowing down a list of stocks to the ones best suited for a portfolio. The best kind of checklist is one that automates the kind of work you would perform on your own. Over the past 25 plus years we’ve done a lot of thinking about (and practical experimenting with) scoring and ranking systems. While we use a number of screens to try and identify stocks with the investment characteristics we’re looking for, a three discipline system remains at the centre of the process.

A robust checklist is a great starting point when building a portfolio; however, our thinking has evolved on why it’s so helpful. When observing the good results achieved by well-ranked stocks against the broad market, it’s natural to assume that the process is working because it selects the stocks with the most appealing characteristics. If this is correct, then there should be equally compelling differences between top-ranked stocks and middling ones; but, this isn’t consistently true, suggesting that the real value in the ranking system comes from eliminating the lowest scoring stocks. For us, this means the bottom 20% of stocks.

It’s important to remember that performance (both absolute and relative to a benchmark) is just as easily defined by what you don’t own as what you do, and maintaining an “avoid pile” has a lot of advantages. The ranking systems that we use will typically drop stocks that are very expensive, have lousy business momentum or a poor technical profile, or are disliked by a respected analyst with a strong track record. Nobody would set out to own a collection of stocks with these characteristics, so having a checklist helps a lot in avoiding the temptation to buy them and enforces some discipline in selling them, even after they’ve deteriorated.

The three disciplines in our checklist are as follows:

The quantitative assessment is a compilation of statistics that most fund managers would find useful in making decisions. In general, the statistics measure the quality and underlying momentum of the operating performance of a business and combine these with a number of stock market-specific measures, like valuation and price momentum. The measures of business performance evaluate if the business is stable, improving or deteriorating relative to its own history, comparable companies and current expectations. Similarly, a number of valuation measures are used to assist in determining if the business is expensive, reasonable or attractive relative to its historical valuation and that of comparable companies.

The technical assessment is driven by the rate of price changes for the specific stock on its own and relative to the market. Identifying absolute and relative price acceleration or deceleration over the intermediate and long-term often signals a shift in perception of a company’s prospects. A system that can signal these turning points has been a helpful tool in our assessment process over time.

For the purpose of the initial screening process, the last piece of the checklist is the expert opinion of a respected observer of the company – an analyst who has had success covering the company from both a financial modelling and recommendation standpoint. This person should know the business, the management and the sector well.

The three ranking systems are combined into an overall quantitative assessment. Together, they represent the first stage in improving the odds of a favourable outcome.

While we like the results of this approach, we would also point out that a checklist doesn’t have to be complex in order to be useful, and we use a number of other “quick” screens in our search for ideas; for example, something as simple as screening for high return on equity (ROE) companies with low financial leverage and high free cash flow yields is a decent first cut at winnowing down the investable universe. The important thing is to pick a checklist that fits with our investment philosophy and suits the character of funds we manage – and stick with it.

Fundamental analysis

The checklist gives us a large pool of companies with above average odds of being good stocks – and, just as importantly, removes a number of stocks with poor odds. However, a list of stocks that represent roughly 80% of the stock market has a couple of practical drawbacks; first, it’s a list not a portfolio and, second, there are far more stocks than we require. The process of paring down a list of stocks and assembling them into a portfolio begins with an assessment of each company. After developing a solid understanding, we then move on to construct a range of fundamental scenarios.

The stock market discounts, or anticipates, future financial results, so we necessarily spend a lot of time focusing on what these results could look like. Company financials, however, are best seen as “counting up” the results of business activity, so in order to understand and forecast financial results, we need to understand the business that produces them. 

Time spent in learning and thinking about the business usually pays off when it comes time to think about the stock.

In our funds, we try and have a focus on good quality companies – they tend to grow in value over time and roll with the punches better, surprises are more often positive and the cost of being wrong in the stock market is usually more manageable.

Factors to consider:

Return on capital employed (ROCE) is important, as it drives value creation over time and is a good metric by which to assess the inherent attractiveness of a business. In addition, ROCE is a good scorecard to use in judging management, as capital allocation is one of the most important jobs of senior management.

The best kind of company to invest in is one that earns consistently competitive returns, has ample opportunities to invest capital at attractive returns and has the free cash flow to fund those opportunities without diluting shareholders or leveraging the company with excessive debt. We’re very aware that the stock market has an amazing ability to sniff out changing returns at the margin and to reward or punish companies accordingly.

We assess management by reviewing their track record, often through individual meetings. Reading several years’ worth of CEO letters (available on most company websites) is a great way to get a feel for management if we can’t meet with them directly. We’re looking for good operational execution of the business and clear thinking on corporate strategy. We often look at business strategy through the lens of ROCE, trying to understand how returns could evolve going forward.

Operating leverage primarily refers to the percentage of a company’s cost structure that is fixed – it doesn’t vary with revenues. When companies have high fixed costs, small changes in revenue will have an outsized impact on financial results, leading to a high degree of cyclicality in earnings and cash flows, which means that even leading companies in industries with high operating leverage can sometimes be very disappointing stocks. These types of businesses can be good investments, but timing plays an especially important role in investment success from our perspective.

Financial leverage refers to the amount of debt on the balance sheet. Debt represents a claim on a company’s assets and profitability that stands ahead of shareholders and can often severely limit a company’s ability to manage through difficult times. In addition, because debt is a fixed number, changes in the valuation of the enterprise need to be reflected through the equity value, raising the potential for highly indebted companies to be much more volatile in the stock market.

We’ll cover our scenario analysis approach next; however, it’s worth remembering that companies with above average operating and financial leverage often have a wider range of outcomes than those without.

The ability of a business to generate free cash flow – cash that is left over after all expenditures associated with the maintenance of current earnings power – is an important factor in judging the quality of a business. Having cash left over after maintenance expenditures are taken care of is a real asset. This surplus cash can be used to grow the business, pay down debt or be returned to shareholders in the form of share buybacks or dividends.

Some of the ways we assess management:

Scenario analysis

We use scenario analysis to establish a range of fundamental outcomes likely to be realized by a company and then work to understand the degree to which these outcomes may or may not be factored into the current stock price.

If the market is always anticipating future events, then spotting opportunity in the stock market requires thinking about how the future might unfold. While most investors understand that there are more things that can happen than will happen, most of us still insist on believing that we have the ability to forecast what will happen. While dampening this instinct is hard, we think that focusing on what can happen pays large dividends when thinking about stock prices.

We work with our internal analysts, company management and analysts at various brokerage firms to model and understand what a company’s earnings, cash flow or net asset value would look like when a company is firing on all cylinders, operating in a normal manner or struggling. We also test these scenarios against past performance metrics to understand if we’re implying that a company will perform in a way that it historically has not.

Once the scenarios have been developed, we determine possible share price outcomes by applying a range of historical multiples to our scenarios. The valuation range is determined using historical data along with other current factors, like interest rates and a dose of judgment. Applying a range of valuation multiples to a range of financial forecasts fills in the grid (pictured below) and provides a range of stock price outcomes as well as some clues about which scenario the current share price is most heavily anticipating.

A “quick and dirty” way to check if a stock might be interesting from a scenario analysis perspective is to look at its valuation based on consensus forecasts. If a stock is trading at a historically low multiple of consensus, it’s likely pricing in something measurably worse and may be an interesting opportunity if the upside scenarios are being ignored. If it’s trading at a high multiple of consensus, then investors are likely anticipating something better, potentially making the stock risky if the market is practically ignoring negative outcomes.

The idea of the stock market as a handicapping machine is a powerful one and scenario analysis is the most important tool we have to assist in successfully calibrating the odds in our funds. It helps us to understand when good companies have the potential to be great stocks.

We have a saying that people would rather be right than rich. In practice, it means that investors will often accept the psychological satisfaction of being with the consensus, even if there is a low payoff, and ignore the lower odds of a high payoff (or a large loss) that requires an out-of-consensus view. Many successful investors have learned to exploit this tendency in the stock market. We think that scenario analysis raises the odds that we’ll benefit from this bias as well.

Making a single forecast creates the potential for bias – focusing only on the information that supports the decision that has already been made. Envisioning a variety of outcomes is liberating for us, particularly in today’s environment, as it provides a road map to deal with a volatile pricing environment.

Technical analysis

As the quote implies, we’ve found technical analysis to be a very useful tool. Alongside our scenario-based approach, we employ it in two ways:

1. To tactically trade positions, where there are no extreme views embedded in prices.
2. As a signalling mechanism for stocks that are pricing in more extreme scenarios. We look for signs that perceptions may be about to shift.

Our technical toolbox is always evolving; however, we’ve come to rely most heavily on intermediate term plots of absolute and relative strength. Augmenting the charts with short and longer term moving averages, as well as some momentum indicators, has also proven useful.

Technical analysis taps into our ability to recognize patterns after repeated exposure to a set of conditions. To employ it effectively, it’s important to personally review the chart patterns of stocks on a regular basis.

Also, technical analysis is a tool that complements the other elements of our approach. Not every decision we make will have optimal technical characteristics; however, we believe that filling our funds with stocks that have lousy charts would be asking for trouble.

Fund construction

Portfolio weights are heavily influenced by risk/reward analysis. In constructing the portfolio, we try and focus on where our scenario analysis indicates that poor fundamental outcomes are anticipated. Conversely, we try and avoid stocks where pessimistic outcomes are practically being ignored.

Stocks discounting pessimistic scenarios can improve in price through a shift in perception, leading to a better valuation, improving fundamentals or, in some cases, both. Stocks that ignore pessimistic outcomes can experience the opposite – shrinking valuations as perception turns more negative or the nasty combination of deteriorating fundamentals along with a shrinking valuation.

It should be noted that most of the time the majority of stocks available for consideration are usually trading within a stone’s throw of fair value. These stocks may still have significant roles in the funds if they’ve filtered well through the checklist and we believe they’re good, well-managed businesses with attractive returns on capital. These stocks perform a workmanlike function in our funds, as they have reasonable odds of compounding their fair value and share prices – hopefully at a higher rate than that of the stock market.

In terms of sector weightings, most of our funds are broadly sector neutral. We think the strengths of our approach are reflected through stock selection. If stock selection argues for a reduced commitment to a sector, we may tilt a fund in that direction, but we try and avoid a top-down approach to sector allocation.

There is a general belief in the investment management business that good stock funds have concentrated positions – built to look very different from a benchmark, with large positive and negative differences in individual stock weightings. A fund that looks otherwise is often said to be lacking conviction, a quality that is presumed to be worth a lot in the stock market.

However, concentration is also the curse of the worst performers. In our view, a well-constructed portfolio has enough concentration to produce good results, but not so much as to become a one-way bet that we’ll be right. There’s an appropriate level of concentration that ensures enough risk is being taken to accomplish our clients’ goals – any risk beyond that level may add to potential returns, but at the cost of adding risk that needn’t be there.

If we do a decent job of assessing the odds in individual situations within our funds over time, the results should be acceptable and the funds are likely to outperform in down markets and keep pace in rising ones. At all times, we try and keep the conversations we have about the positions in the funds anchored around process, with an open mind to negative outcomes for stocks we own and positive outcomes for stocks we don’t. We find this is better than falling in and out of love with stocks, which can hamper good decision making.

Concentration without process can be particularly damaging. A concentrated portfolio anchored around a set of high-conviction beliefs often makes removal of a position in response to signs of trouble extremely difficult. It’s impossible to be right all the time, so we don’t manage our funds in a way that requires us to be right all the time.

The rationale for building a portfolio in the first place is the acknowledgement that we can’t always be right. Overconfidence in one’s abilities to forecast the future, when mixed with large portfolio bets, can be a toxic recipe.

While some great long-term investment track records have been assembled from periods of performance that differ widely from benchmarks in both directions, we believe that an approach that minimizes performance volatility has its own benefits. Periods of significant underperformance necessarily require a period of significant outperformance later on in order to produce good long-term results. In our experience, performance that comes together in this manner raises the risk that a lack of patience or other timing issues will interfere with long-term results.

Decision making

Decision making in our funds is an ongoing effort to consistently improve the odds of a favourable outcome. The biggest aid to successful buying and selling in the funds is scenario analysis.

Having identified the handful of stocks that are heavily anticipating extremes of pessimism and optimism allows us to react well to modest changes at the margin in fundamentals and sentiment. This goes for fine-tuning positions that are closer to fair value as well. The quantitative and technical inputs are often useful in spotting these sometimes subtle changes at the margin.

If we’ve thought carefully about the positive and negative developments that can affect a stock in advance, we think it raises the odds that we’ll react well to evolving information at the margin. We believe this is true for two reasons:

1. We should’ve already thought about the implications of the scenario and can react quickly while others are adjusting to new developments. Some of the hardest decisions involve stocks that open dramatically higher or lower on news. While anchoring the move in the stock against yesterday’s price usually makes the reaction seem “crazy,” these types of events are often pivotal moments. If the scenario analysis is done well, the size of the prize in both directions is understood and we can better deal with market volatility.
2. We believe that having thought about a variety of outcomes (as opposed to anchoring around just one) will help us be more open-minded to receiving new information. Investors who are betting on a scenario that they have personal conviction in may be more likely to dig in their heels and reject information that contradicts their thesis.

The process that we use is workmanlike and ongoing. Does the stock pass the checklist? Does the company have attractive fundamental qualities? What scenario is priced into the stock? What do other scenarios look like for the stock? Does the stock have attractive technical characteristics? The stock market is a relentless competitor; if portfolio positions are regularly re-evaluated in light of these questions, then the odds of success are higher. 

We feel the scenario approach we use helps us to achieve the right temperament by approaching situations in a manner that’s open to a number of different outcomes and by focusing on observing rather than forecasting. There are no style points awarded in investing – results are all that counts.

A note on temperament

Temperament and self-awareness are important ingredients in a successful investment process. The lessons we’ve taken away from our experience to date would include the following observations: