Through a fundamental, bottom-up investment approach, portfolio managers Mark Dickherber and Shaun Nicholson have a goal of identifying smaller-cap companies with the potential for significant improvement in return on invested capital (ROIC). The idea being that as ROIC improves, each dollar invested in the business earns an incrementally higher return. Dickherber and Nicholson define ROIC as net operating profit after taxes (NOPAT) divided by the adjusted asset base (the “invested capital” of a business or business segment). The adjusted asset base includes goodwill and other intangibles, on the basis that any management decision from a capital allocation perspective has to be taken into account. They characterize attractive ROIC levels as those they believe will be sustainably above a company’s cost of capital.
One of the first steps in narrowing the universe is using a quantitative screen that ranks companies within industries by decile using return on enterprise value (ROEV). The ROEV metric measures, as a percentage, net operating profits after taxes (NOPAT) based on businesses’ current enterprise value. The names that fall into the cheapest three deciles within each industry are where the team focuses their analysis. Potential ideas also come from a screen that highlights companies that recently suffered steep stock-price declines, as well as from a newsfeed that reports what companies have had a change in management.
From these subsets of companies, Dickherber and Nicholson start their ROIC analysis, where the goal is to identify companies where management is properly incentivized to implement change that markedly improves returns through appropriate capital allocation. To help identify these improving ROIC opportunities, the team uses a proprietary tool referred to as the “dashboard,” designed to efficiently illustrate a company’s historical aggregate returns and returns by business segment. In addition, the dashboard provides data sets such as working capital, cash flow trends, and asset growth. The team uses this data to understand the business, management’s historical capital allocation decisions and business returns, and ultimately to help identify catalysts for a potential positive step change in a company’s ROIC profile. Importantly, the team requires that management be compensated based on ROIC, or components of ROIC, which the co-managers believe improves the odds of management making good capital-allocation decisions.
A critical step is challenging management on ROIC claims. The team will not invest without an in-depth conversation with the company. Dickherber and Nicholson question management to assess their understanding of the business, and the game plan for improving returns. (Company management is free to talk about specific strategies for improving returns, while regulations prohibit management from discussing future quarterly earnings and revenue estimates.) Dickherber and Nicholson want management to be clear and intentional about what happened to the business, why it is happening, and what can be done to improve returns. They want management teams working to drive positive long term returns, as opposed to making short-term decisions to drive quarterly revenue and earnings results higher. Revenue and earnings growth is critical, but they don’t want higher earnings at the expense of deteriorating ROIC; it should be the result of appropriate capital allocation. The co-managers track management’s progress via quarterly financials and regular management contact.
When defining whether a stock price is attractive, Dickherber and Nicholson emphasize reward-to-risk ratios and require a 3:1 upside/downside. The team strives to guard on the downside; they will run stress tests at the company level as well as market scenarios to understand how portfolio positions might behave. (Macro considerations do not play a role in the team’s allocation decisions.) Dickherber and Nicholson seek to identify the building blocks of improved (and diminishing) profitability before it is recognized by the market. As improved returns are reflected in the stock price, portfolio holdings are trimmed, and ultimately sold when they reach the team’s estimate of fair value.