Lyon Capital Management’s Buy Discipline
Our focus is on individual companies. We use a bottom-up approach. While we are certainly aware of the current economic conditions and economic outlook, this is not the focus. We strive to purchase companies that will do well in strong as well as weak economic conditions.
As part of the equity portfolio we add a weighting of Real-Estate Investment Trusts (R.E.I.T.s). In fact we treat R.E.I.T.s as a separate asset class because they behave differently than (have a low correlation with) other stocks and bonds. This makes them great portfolio diversifiers. We use R.E.I.T. stocks traded on the major U.S. exchanges.
We do not make sector bets. We develop a diversified portfolio, but selecting and altering sector weightings is not part of the strategy. We also do not make bets based on market capitalization (i.e. we cannot be categorized as a “small cap” manager or a “large cap” manager).
We focus on individual companies, substantial businesses, with a proprietary product or competitive advantage as well as a diversified customer base. We only buy when a stock is down in price from a recent high and selling at a low relative valuation compared to other companies in the market and other companies in the industry. This indicates a stock that is out of favor with most investors. We invest in companies that are industry leaders and that generate good returns and strong cash flow. We look for companies with strong or improving balance sheets. We like the company to pay a dividend.
We evaluate management and look for a streamlined team with a small, independent board. We like to see significant share ownership by the management and directors. We like a board size of not more than 11 (any more dilutes decisiveness). The board members should not be on more than 3 or 4 other boards. For top officers the value of the stock holdings should be at least equal to salary. Management should be focused on growth and profitability.
A fully invested equity portfolio at Lyon Capital Management is equally weighted between 20-30 different issues, divided among 10 to 15 different industries. This allows for good diversification without nullifying the value added by the stock picking method described above. Portfolios are built gradually over time as we select stocks that are currently undervalued and establish positions in them. It may take as long as six months to a year for a portfolio to become fully invested. Portfolio turnover is relatively low, therefore minimizing trading costs while maximizing return. Past volatility of returns has been low and we provide evidence of this on our performance data sheets. We believe the risk one takes when investing is just as important as the returns generated.
We purchase securities listed on the major U.S. stock exchanges. International exposure is gained by selecting companies based in the United States that have a strong presence in foreign countries. When one invests in a stock like Applied Materials or McDonald’s, companies who do a large portion of their total business outside the U.S., one is in effect hiring the best foreign business managers to make decisions about foreign markets. These managers know the market, in many cases, live in the market and are familiar with the economic and political situations. We believe they are better positioned to make smart international investing decisions than we are or than are most other money managers based in the U.S.
When we do decide to invest in a company we look for that investment to generate a return of about 50% over a 3-year period. When we buy a stock, we’re not looking at making a quick profit. We are long-term investors. We are not market timers. We believe patience and sticking to one’s investment discipline are the keys to sound long-term results.
The sell decision is as important as the buy decision. The parameters of our “sell discipline” begins with establishing goals for what we expect a stock to do. When we first purchase a stock we have a goal for the up-side of the investment. To put this in more concrete terms: the upside goal is to achieve a gain of 50% over three years, which is a 15% annual return plus any dividends. When the stock reaches the up-side goal we often take profits by selling some or all of the position. If the stock appears to have strong fundamentals and continued strong growth potential, we will continue to hold a portion.
We also have an idea of how low we think the value of the investment could possibly go. We recognize that stocks don’t always go up, even when we have done our best to select investments we think will increase in value. When a stock goes down more than 20% from the original purchase price then we re-evaluate the investment.
One may ask, “Why 20%?” Simply put sometimes out-of-favor stocks (the type of stocks Lyon Capital Management buys) go down before they head back up. Unlike many other investors we are not buying stocks already on the rise and selling at the first sign of bad news. Often the companies we buy may go lower because of recent bad news or market trends. In addition, in today’s more volatile market it is not unusual to see large swings in the value of a stock. A stock may go down rapidly 5, 10, even 15% and then quickly rebound. If one has a discipline to always sell when a stock is down, say 10%, one may miss out on an opportunity and incur an unnecessary loss.
A decision to sell is based on how the company is performing. We ask questions such as: Is management following through on their stated initiatives such as cutting costs, selling off under-performing divisions, or expanding in new markets? Is the company’s debt level falling? Are margins improving? If the answer to any of these questions is, “ No,” we re-evaluate whether or not we should continue to hold the investment and we may sell. It is important to exit a position when one has lost faith in the investment.
If, however, the reasons we bought the stock in the first place are still in place, a lowered price is an opportunity to buy more. And often that is what we do. If we have strong confidence in the stock, even after a 20% drop, we’ll purchase more.
To hedge, when we first start investing, we sometimes buy a small position. The idea is to begin small and then add to the position as the price goes down. When we buy we try to do so at what we believe is the lowest price; however, buying at the lowest possible price is almost impossible and is almost a matter of luck. So when we buy at what we think is a good price we are fully prepared for the price to go lower, to take advantage of this and buy some more.
The bane of buying undervalued out-of-favor stocks is that they can become more out-of-favor (meaning the price goes lower) before the value is realized by the marketplace and the price goes up. The reward is buying quality companies at bargain prices, and earning good returns on investments while taking below-average risks. It is a strategy that may not be as glamorous as buying a stock when it is on the rise, but it certainly carries less risk. And for conservative, patient, long-term investors it is a desirable, and often more rewarding strategy. $$