Finding Quality and Growth at a Discount
First Investors Opportunity Fund
Edwin Miska, Steven Hill
Author: Ticker Magazine
Last Update: Aug 28, 10:10 AM ET
|Investing in well-established companies with growth characteristics tends to provide added value when the purchased stocks, or their sectors, are suffering from temporary problems. Steven Hill and Edwin Miska explain how the core strategy behind the First Investors Opportunity Fund blends a bottom-up selection process with a catalyst-driven approach to build a portfolio of quality stocks across a flexible market-cap range.
“We emphasize catalysts, or the discrete events and/or moments in time that will lead to earnings acceleration or enhanced shareholder value. In other words, we look for companies with growth-like components and try to get them at a reasonable price.”
Q: What is the history of the fund?
The First Investors Opportunity Fund was started on August 24, 1992 to take advantage of the strong growth opportunities offered by small- and mid-cap companies. Although the fund originally invested in firms manufacturing products in the United States, in 1998, this mandate was dropped. Foresters Investment Management Company, Inc. is the fund’s investment adviser, and Steven Hill and I joined the firm in 2002 and now serve as co-portfolio managers.
The fund’s market-cap range is fairly wide-ranging. It differs from traditional mid-cap funds because its broad mandate also allows us to invest in smaller-cap companies, although we pay little attention to the micro-cap space. Given the size of the fund, a certain level of liquidity is necessary and market caps between $1 billion and $15 billion provide a robust playing field. Typically, we don’t go below $500 million, and the Lipper-defined definition of large-cap companies we use sets a ceiling at around $20 billion.
However, we don’t necessarily sell stocks once they reach that large-cap mandate. If a company is quite successful and the stock keeps rising and performing well, we can continue to hold it through a full cycle and take advantage of that appreciation.
Q: How do you define your investment philosophy and process?
We are a fundamental bottom-up investment firm and eschew market technicals. Although we do use quantitative analysis for screening and maintenance, we strive to understand the stocks in which we invest. This means our fundamental research extends far beyond merely reading financial statements, and ultimately allows us to form a long-term point of view on a company’s investment prospects.
Our shareholder base is fairly conservative and long term so we’ve always used disciplined processes. We buy higher-quality companies than many other mutual funds, and look for those that are consistent in their results, and are able to grow their earnings, cash flow, and dividends, as well as have a focus on returning cash to their shareholders. Unprofitable companies have no place in the fund and are screened out.
These higher-quality companies may not outperform every year or in a shorter cycle. But over longer periods, they aren’t dependent on the markets to generate the capital needed to execute plans, which should allow them to garner premium valuations over time, particularly if they get bought out, as many names in our portfolio do.
As a core fund, we don’t have a bias toward either value or growth stocks. We emphasize catalysts, or the discrete events and/or moments in time that will lead to earnings acceleration or enhanced shareholder value. In other words, we look for companies with growth-like components and try to get them at a reasonable price.
We won’t invest in early-stage biotech names or internet companies with price-to-earnings ratios of 100 to 300. Instead, it’s our belief that earnings have a reasonable valuation that we can assign to them, with some variations by sector and perhaps even subsector. The fund is positioned as growth at a reasonable price, but our ideal definition of “reasonable price” means somewhat undervalued, rather than deep value.
Ultimately, our aim is to find stocks that are out of favor or have a temporarily depressed price due to a technical reason like a sector sell-off. When our interest is piqued, a fairly deliberate fundamental process is used to then evaluate whether something belongs in the portfolio.
Q: What is your research process?
There are thousands of small- to mid-cap companies out there, which we eventually narrow down to just 20 to 30 interesting names using quantitative screening models, then layering on our valuation discipline and looking for an earnings growth inflection.
The quantitative tools we use vary by the market; for example, the one used in 2003 was most definitely not what we used in 2010. Today, even the latest Presidential election has led to modifications. Ideally, from among those thousands of companies, we want it to identify ones with forward price-to-earnings of less than the markets, and attractive price-earnings-to-growth of less than 1 times, typically – although recent trends have forced us to be more aggressive than usual because of the latest phase of bull market.
On a high level, we look at important metrics like positive earnings revisions and evidence that the next sequential or seasonal quarter is going to be up. To us, these signify an earnings inflection, meaning that earnings are starting to accelerate. We also look at liquidity and leverage ratios like net debt to EBITDA; although this varies somewhat by industry, a number greater than 5 is generally alarming.
Next, employing our disciplined valuation process, we look for an earnings growth inflection, which leaves us with 20 to 30 interesting names at any given point. We have a team of 14 investment professionals total, of which there are seven industry analysts who follow individual sectors. Several small- and mid-cap generalists supplement the analysts work, and help us with research; their job is to get in touch with the companies, go through all the public filings, and meet with the management to discuss their strategy.
Our analysts dive into the stories more deeply to figure out the growth strategies of these companies and what is behind their rising numbers. They analyze recent company results, market expectations, and how they have done relative to their own guidance. We typically won’t buy any new names without first having a meeting or phone conference with company management.
If this analysis points to a higher number than what the Street or the market might be expecting, or the possibility of a higher number based on the company’s explanation of what is going on – that’s what gets our attention and gives a stock the potential to be put in the portfolio.
Q: Can you describe your research process with a few examples?
In May or June of last year, a company that popped up on our screens was VCA Inc, the animal healthcare company. Ironically, the name had always previously screened as expensive. We dispatched our analyst to see if there was in fact an earnings inflection – obviously, it had screened as such, but that was based on sell-side estimates.
We confirmed the inflection point through our own work. Essentially, VCA had made a hospital acquisition that didn’t work out as expected; the company had overpaid a bit and it was going to take longer than anticipated to get the cost of the hospital out.
Although management was cagey, we determined it had the potential for operating margin expansion over the next 12 months based on the company’s track record in prior acquisitions, which signaled an opportunity for us to invest. However, this past January, MARS, Incorporated acquired the company. It still worked out quite well for us: in just six months, we had approximately a 50% gain from our initial purchase.
Mergers and acquisitions (M&A) are an underlying theme among the companies we invest in – it’s something that underpins our thesis nine times out of ten. We analyze what a stock might be worth if a company were to be acquired, and if acquired, who the likely acquirers would be.
Since the financial crisis, mid- and small-cap companies have benefited from being domestically focused. They’ve taken advantage of extremely low rates to readily borrow money, and as well, they’re generating earnings and cash flow faster than many larger multinational companies.
Largely flush with capital and with the ability to borrow, many of our names have embarked upon merger strategies of their own. The rising earnings result from companies merging, rationalizing costs, and getting synergies on sales.