Investment Committee Interview
To gain further insight into how Boston Research and Management manages client portfolio's, we sat down with members of the Investment Committee for an in-depth Q&A.
How do you customize an investment strategy for an individual client?
Boston Research and Management (BRM) customizes investment portfolios to meet the unique needs of each and every client. The first step is finding the appropriate Strategic Asset Allocation – the right amount of stocks, bonds, and cash to meet the client’s objectives. Essential inputs to arrive at the correct allocation include factors such as income needs, tax sensitivity, risk tolerance, time horizon, and liquidity needs.
Analyzing these factors with our clients enables us to establish unique tactical asset allocation ranges based on their objectives and constraints. Through continuous analysis BRM may find that certain asset classes become significantly over or under-valued at any one point in time. This is when we make a tactical decision to under or over-weight an asset class within its appropriate range to best preserve and grow capital for our clients. The effectiveness of this discipline was clearly shown in the year 2008. At that time, we felt bonds were relatively undervalued (above average yields) compared to equities that were richly priced. Therefore, we positioned portfolios at the low end of their equity range and increased our bond weightings. The opposite was true in the beginning of 2009 when bond yields were at inferior yield levels and there was an abundance of excellent businesses that could be bought at attractive valuations. We feel market timing is a futile effort, but a disciplined approach of analyzing asset classes based on valuation is prudent portfolio management.
What is your investment process for the equity component of your managed portfolios?
We start by assessing the macro-economic environment. We study the economy, interest rates, and inflation to the degree that we can arrive at some secular (long-term) conclusion to how these factors will affect underlying asset classes. We want our underlying asset class ranges to be in harmony with secular trends. At this point, our bottom-up investment approach begins. We spend considerable time evaluating investments on their own merits.
Equity securities are an essential component to all portfolios because they have the ability to appreciate over time and provide a source of income by way of dividends. Because inflation is always a real threat to our purchasing power, the growth attribute of equities becomes even more important.
Our Equity Discipline is simple: buy excellent businesses at attractive prices. First and foremost, an excellent business has a durable competitive advantage allowing the company to earn extraordinary profits. The durability or sustainability of the company's competitive advantage is a very important part of our analysis. All of the businesses we invest in would be extremely difficult or impossible to duplicate and have high barriers to entry. Many are protected by: patents, consumer monopolies built on brand awareness, and/or are the low cost provider due to size and scale.
In our search for excellent businesses we are constantly evaluating a universe of over 5,000 publicly traded stocks. These companies that make up our circle of competence typically are US based and have a market capitalization above $2 billion (covering the Mid-Large Cap spectrum). We have found that roughly 450 of those businesses are worthy of being defined an excellent business and have further defined an elite list of 100 (BRM 100) that are the cream of the crop.
We have found the sea of mediocre businesses an unprofitable place to navigate. These companies typically sell a commodity-type product and have little pricing flexibility, inferior economics, and operate in extremely competitive industries. We also will avoid those businesses that we do not understand. If we cannot determine how their business works and how it might look 5 years from now, we feel we are better off investing in one that we can. We want to operate within our circle of competence.
The difference between a great business and a great investment is the price one pays. We feel very strongly that the price we pay will determine our rate of return. Evaluating the worth of these companies is one of the most important things we do. We determine the value of a business and compare it to its current price. We buy only those companies trading at a significant discount to intrinsic value. We like to buy $1 worth of a company for $.50. This gives us a margin of safety that can help limit the downside during periods of volatility.
Businesses sell at a discount to their value for a variety of reasons; broad market moves based on fear or greed, one-time calamities in a business, recession, war, structural change, etc. Investors often act in a short sighted manner, buying or selling stocks based on recent events without thoroughly analyzing the long term effects to the business.
Our Equity Portfolio contains about 35 – 50 of the best businesses we can find at the most attractive prices. We measure all stocks in our narrowed-down universe and in our portfolios based on their expected return from this point forward.
How does the investment committee infuse fresh capital into the equity market?
We have observed that many investment firms simply arrive at a strategic asset allocation for their client and then immediately place them into the securities of their model portfolio. We feel this approach falls short of what makes investment sense and does not customize the asset class or security selection based on the relative value at that point in time. We customize not only the investment strategy for each and every client but we also customize the implementation process by assessing the unique objectives and constraints of our clients. We will look at where we want to be within our tactical asset allocation range given the relative valuations of stocks, bonds, and cash. Furthermore, within the tactical equity asset class decision, we feel a more effective approach is to tailor the timing of buying decisions. Stock purchases are prioritized based on value and confidence. Thus a new client or a new cash infusion is only being invested in the best ideas with the most robust expected returns.
One of the agenda items for our investment committee meetings is to re-sort our portfolio of securities into four tiers. We refer to this exercise as our Tier Review. Tier 1 securities are those securities that offer the best forecasted Internal Rate of Return (IRR) and our highest confidence of attaining that forecast. Tier 1 companies typically number 10 – 15 holdings. Tier 2 securities are a further select group of companies that are excellent investment candidates at current prices. Tier 2 companies will represent 10 – 15 holdings. Tier 3 companies are those that we have decided not to add new money to that week due to a decline in the IRR forecast. A strong move upward in the stock price may diminish our future returns for new investment. We also may be analyzing a change in fundamentals that could change our estimates and we would not want to add new money to that holding until we complete our research. Tier 3 companies can represent 10 – 15 securities. Tier 4 companies are those that we are considering selling. The company may have met our valuation target or a fundamental change in the business could change our investment thesis. We will then begin to discuss candidates from our stable of “on deck” investment ideas that we are constantly researching to replace the particular holding. Tier 4 companies can represent between 0 – 3 holdings.
What is your sell discipline?
We sell an investment when our forecasted return is inferior to other potential investments. We measure our forecasted returns in terms of annualized IRR percentages (internal rate of return). This is the forecasted compounded total return between today and a future date. This percent return forecast is an apples to apples comparison across all potential investments regardless of asset class. If we cannot find an excellent business to buy at a return better than bonds, we then look at making tactical shifts to increase bonds at the higher relative yields and reduce our equity exposure. As a company's share price rises it will approach our forecasted intrinsic value of the business. We must then analyze the tax ramifications of selling the equity and compare the forecasted return on the equity to other available investments. If the gains from buying a new higher returning equity outweigh the costs from taxes we will sell the equity and replace it with the higher returning investment.
Another reason to sell an equity holding would be if our opinion of the business has changed. Its profit model may have been altered or negatively affected by state or government regulations or other reasons. If we feel the company no longer has a durable competitive advantage or estimate that the intrinsic value of the company has decreased we will sell.
Do you use stop losses and how do you react to a falling stock price?
We do not use stop losses. Although it sounds contrary to what you might think, at times we can use lower prices to our advantage. Particularly, if we are building a position in an investment we can buy more of the company at a lower price, which will lower our average cost. We feel the market will fairly value securities over the long-term but in the short-term there are many non-fundamental factors that will drive stock prices. As Warren Buffett often has quoted his mentor Benjamin Graham, “in the short term the market is a voting machine but in the long term a weighing machine”.
We will use “stops” to retain gains as we wait for a more tax advantageous time to sell an investment. For example, if an investment is only weeks from becoming classified as a long-term capital gain we may use a stop.
Truth be told, when the price of one of our investments is going down we are never content. Our research efforts go into overdrive and we triple check our conclusions. If our reasoning is still sound we will use the price weakness to our advantage.
How do you think about taxes in your investment process?
BRM is focused on managing money for individual investors and their families. Most of our clients have at least one taxable account that we manage. Taxes are a very important consideration in the management of client portfolios. Many of our clients have a tax deferred account such as an IRA or Profit Sharing Plan that we can use to complement their taxable account. Less tax-efficient investments are suited for these tax-deferred accounts. In taxable accounts we manage our clients’ losses and gains to take advantage of the current tax laws. For example, we often harvest losses to offset gains if they make investment sense and we try to wait for investments to be classified as long-term gains to receive the benefit of the lower capital gain rate.
How did you develop your investment discipline?
We have tried to emulate success. As our team has collectively honed its skills over the years, we have found our most valuable teachings have come by studying the best. There are many style similarities among some of the elite managers who have compounded the highest annualized returns over 10, 20, and 30-year intervals. Among this group, we have not found any traders, economic gurus, or market-timers. The elite managers all understand the power of compound returns to a portfolios value. They understand that to arrive at outstanding long-term returns, you must have a discipline and adhere to that discipline in any market. All of these investment masters are value investors – first they understand what they own and most importantly they buy the investment at a discount to its intrinsic value. Their portfolios are not overly diversified but are concentrated with the best ideas of the manager – usually reflecting 40 or less core positions. These masters understand the need to be prudent regarding unnecessary capital gains and transactions costs that come from excessive turnover.
We continue to emulate success, customize our research efforts and are constantly uncovering and analyzing the recent investment moves of these proven masters.
How does Boston Research and Management define their Equity Investment Style?
The definition of who is a value investor versus a growth investor is increasingly confusing. Every investor’s goal is to buy something at a lower price than what they can sell it at in the future (value). Growth is simply an input that allows one to compute what the business is worth. Our goal is always to make prudent investments that have a low probability of potential loss and a high probability of superior returns. We would best describe our style as one of being “selective contrarians.” We are contrarians in the sense that we find the best value when other investors are focusing on the short-term issues and ignoring the long-term fundamentals of an outstanding investment. We are selective in the sense that we only want to buy the most outstanding businesses that can recover from short-term events. We do not want to buy just because a company is down and out. We want to buy when excellent businesses are being mispriced by the market. Often times our best investments have been made when it seems that everyone else is selling.
How do you define and minimize risk?
We think of risk as we believe our clients do and that is the permanent loss of capital. Our #1 goal when managing client portfolios is to preserve capital. Our next objective is the intelligent growth of that capital within the Investment Strategy parameters collectively agreed upon between BRM and the client. We do not speculate on any investment. We try to minimize risk by knowing all there is to know about our investments and then buying them at a margin of safety, a discount to their intrinsic value. During periods of asset class overvaluation we will tactically shift capital toward those asset classes that have a better chance of preserving and growing capital.
How do you measure your success in managing individual client portfolios?
We measure our success by achieving the jointly predefined investment strategy and service goals we have set with our clients. Our structure was created to align our client’s success with our own. By providing superior service and by continually challenging ourselves to provide outstanding absolute and relative returns, we feel we will achieve collective success and retain clients for life.
How do you envision Boston Research and Management changing over the next decade?
We still have the capacity to add new clients with similar philosophies to our own and grow our asset base without changing the nature of our business. Most importantly, we feel we can grow and still deliver the superior service our clients have come to expect. We will add the necessary staff to support our needs both on the operations side and research side before the needs become apparent. We continually invest in technology to improve our research effort as well as our communication with our clients and the dissemination of information within the firm. We have always positioned ourselves to manage success and growth by installing the necessary building blocks in advance. However, there may come a day when we close to new clients in order to maintain the culture of the firm. We enjoy the intellectual challenge of our research process and the satisfaction of helping our clients meet and exceed their investment objectives. Where some look forward to retirement, we look forward to having our intellectual capacity to continue to do what we love to do for as long as we are able.
How can Boston Research and Management compete against larger firms with unlimited resources?
In the money management business bigger is not better. In fact, size often becomes a liability to providing superior absolute and relative returns not to mention providing outstanding service. We find larger firms adhere to what we call the “institutional imperative.” The firm’s investments are driven by the decisions of investment committees that spend more time analyzing the index and minimizing variances to that index than on researching outstanding investments. They have analysts that know every intricate detail about a sector or business but have a very difficult time understanding value. We see them in our one-on-one meetings with management from time to time and are often baffled by them missing the important drivers of a business. The investment managers we most respect tend to gravitate toward smaller firms where there is a focus on pure investing and servicing a select group of clients that have similar philosophies. The managers we know who have put up the most outstanding track records, which we measure in decades not just years, are run by teams of less than ten people (oftentimes less than 5 investment professionals).
We feel our structure is further strengthened by our team approach. We discuss and debate all investment considerations until we are all in agreement before a prospective investment is initiated.
We put a premium on independence. We spend very little time studying Wall-Street research except as a barometer of consensus thinking. There is significant amount of “groupthink” that takes place in the money manager community and we prefer to distance ourselves from the herd. We choose to build our own financial models and arrive at our own conclusions which we feel gives us an advantage over the majority. Our office is located in the town of Manchester-by-the-Sea, an adequate distance from maddening noise of the financial district. Most of our professionals live at a close proximity to our office. We find this valuable as some of our best research efforts take place after the bell and when the phone is not ringing. Our software vendors have often commented on how robust and advanced our financial models are compared to those of some of the largest, most prestigious firms in the country. We take great pride in our research efforts and their direct result to driving successful performance.
What is the Investment Committee’s view on Fixed Income Management?
We feel that having a properly balanced portfolio is essential to long term growth. Fixed Income plays a very important role in many of our portfolios. We design, build and implement laddered bond maturities unique to each client. Unlike a fixed income mutual fund, we own bonds directly, and therefore control the maturities and durations of the portfolios.
Since bonds are simply an inventory item for brokerage houses, we use up to six different bond vendors to help ensure we are obtaining the best price. If using just one broker when looking for a specific bond, they may be forced to first buy it in the open market, then mark it up before selling it to the investor.
Additionally, having this network of bond traders allows us to take advantage of late day odd-lot sales. Very often bond brokers look to us to help them by purchasing small pieces of leftover bonds at discounted prices in order to clean up their books. We can allocate those bonds to any of our clients at any time.
How do changes in the interest rate environment affect your Bond Management?
We use multiple economic models to garner information about the direction of interest rates. During a period of time that we expect rates to be higher in 2-3 years; we would keep the duration and maturities short in order to have cash available to participate in tomorrow’s higher rates. Alternately if we feel today’s rates are more attractive than we expect them to be in the future; we’ll capitalize on this by expending our bond ladders further into the future.
We also constantly evaluate the after-tax return of our Bond portfolios for each client to determine if a tax free municipal strategy is appropriate or if they would be better served by a Treasury or Corporate bond portfolio.
How can you protect the portfolio against inflation?
Protecting purchasing power is almost as important as protecting principal. Inflation has averaged roughly 3% historically and over the last ten years has been slightly more subdued – in the area of 2%. The best way to protect portfolios against this risk is to have investments that have the ability to appreciate over time. When looking at a company for purchase we always ask the question: “Can this business increase prices with inflation?” The answer always has to be yes – they need to have pricing flexibility. We also mitigate this risk by owning businesses that tend to pay dividends and more importantly grow their dividends every year. As a shareholder we are in essence getting a raise every year as they grow their dividend over time which helps to offset the rising cost of goods and services. The average annual growth rate of our dividend payers is typically in excess of 10% - a very nice inflation hedge.
How do you access other traditional asset classes like International and Small Cap?
We agree that there are regions of the world that have different growth characteristics than the US and are worthy markets for consideration. Many of our company holdings have significant direct exposure to International Markets. For example, Procter and Gamble receives 55% of their revenues from outside the U.S. and has dominant market shares in many of their international markets. They sell products in over 180 different countries and earn in excess of $1B in revenues in 12 of those countries. Another example, McDonalds, derives more than 65% of their revenues outside of the United States. We also use low-expense Exchange Traded Funds (ETFs) to gain exposure to a particular asset class that would not be served by our individual stock and bonds holdings. For example, we have used ETFs to access the S&P Small Cap 600 Index, which gives us direct exposure to small cap equities.
Does BRM ever invest in alternative asset classes such as commodities or currencies?
Our unique structure provides us with the opportunity to specifically design investment vehicles which allow us to participate in market discrepancies we perceive to exist across all asset classes, from commodities to currencies and beyond. We have used principal-protected structured notes that limit the traditional downside in these volatile asset classes while not removing any of the upside participation.
How would you characterize your current portfolio of businesses?
We own about 35 – 50 core businesses in the equity component of our client portfolios. Most of these companies are the #1 or #2 player in their industries. They are protected against competition by high barriers to entry or duplication of their business model. Most have very little debt and could pay off all their debt in less than 2 years with their operating earnings. All of these companies have had a growing and predictable stream of cash earnings. They have high returns on shareholders equity – many above 20%. This portfolio contains businesses that have either brand name awareness with the consumer or serve as a conceptual “toll-bridge”, where by businesses must use their services to access their end customer. Average EPS growth is around 10%. All have a defined plan on building shareholder value through dividends and/or share buy backs. Many have a limited variance in the demand for their goods and services and even continued their consistent performance through the latest recession.