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Decision-Making Process

Multi-Factor Valuation

We employ a multi-factor valuation model that emphasizes four categories of variables: value, management, momentum, and sentiment.

Value — We examine price-driven measures using the balance sheet, cash flow and income statements. We consider the balance sheet because asset-rich companies resist market declines and are prime takeover targets. On the income statement, earnings yield (the reciprocal of P/E) is among the more robust measures of a stock’s fundamental valuation for U.S. stocks, as the more earnings for every dollar invested, the more attractive the security. On the international front, cash-flow yield (the reciprocal of P/CF) is prized as greater cash earnings indicates higher quality; dividend yield is also influential.

However, value alone is an insufficient investment signal. A company may deserve a low multiple if there’s no prospect for growth or evidence of successful management. Our valuation model considers the relative success of management as important as assets, profits, cash flow, and dividends.

Management — Our so-called management factor quantifies management’s operating efficiency and profitability by measuring the basic underlying performance of a going concern. We use a composite of variables to provide a profile of management savvy:

Consistent with the goal of all security analysis, we combine these measures and financial ratios to improve our success in discriminating future corporate performance.

Momentum — We rely on momentum to assess Wall Street opinions in real time. We define and measure momentum in three dimensions:

Momentum helps anticipate future leaders and laggards.

Sentiment — We scrutinize the actions of informed participants — the “smart money,” if you will — to decipher their investment views and derive alpha indications from their purchasing and selling behavior.

Since quantitative evidence of sentiment isn’t available worldwide, its inclusion is limited to markets with robust data.

Contextualization — Profile Matters

Each measure varies in influence, determined by a company’s profile, investors, and market. Its profile includes region, industry, size, growth characteristics, beta, volatility, and institutional ownership. For example, gross profits relative to enterprise value is a better indicator of value for software companies than for producers of household durable products; sentiment measures tend to be more powerful among small-cap issues than large-cap; and price-relative strength is a better predictor of future stock prices among higher-growth stocks.

We add yet another layer of understanding by considering the significance of a stock’s global or regional emphasis.

Whole Caboodle

In the end, we derive an all-in excess expected return for each company. All-in means we boil our multi-factor valuation down to a single number; excess suggests above (or below) the level of the market; expected indicates forward-looking. Each stock’s summary measure of attractiveness carries across all of our strategies.