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Unanticipated Acceleration in Returns
Oppenheimer Mid Cap Value Fund
Interview with: Laton Spahr, Eric Hewitt

Author: Ticker Magazine
Last Update: Jun 16, 11:25 AM ET
Although out-of-favor stocks are generally facing serious business challenges, many of these companies could become profitable opportunities if an investment strategy takes into account how core issues are reflected in metrics, both historical and projected. Laton Spahr and Eric Hewitt, portfolio managers of the Oppenheimer Mid Cap Value Fund, apply the unorthodox approach to understanding value as a function of expectations at the company and market level, with the objective to identify and evaluate unexpected positive changes.

We believe that the value of a public equity is as much driven by behavior and narrative as it is by cash flow and interest rates.
Q: What is the history of the fund?

A: The Oppenheimer Mid Cap Value Fund was originally launched on January 3, 1989. Eric and I, the co-managers of this fund, took over in 2013.

Q: How is your fund different from its peers?

A: Our objective is to outperform the funds benchmark, which is the Russell Mid-Cap Value Index. We aim to accomplish that by maintaining comparable systematic portfolio risk and then add value from a bottom-up stock selection. We do not just focus on the cheapest quintile, or the market based on price-to-book or price-to-earnings, what we are really motivated by is identifying what we call unanticipated acceleration in return on invested capital (ROIC).

We identify assets that look statistically cheap and try to understand what the expectations are that are causing that apparent cheapness. Our research effort is built around contemplating changes, at the company or market level, including changes in revenue growth, profit margin, and asset efficiency. For a value investor, that approach is fairly uncommon.

Q: What core principles guide your investment philosophy?

A: We take the contrarian view that value is defined by an evolving market perspective, as opposed to a universal truth that is intrinsic. . Our research process is built around a three-part framework that interprets value relative to expectations, estimates how those expectations might change, and then evaluates any changes. We believe that the value of a public equity is as much driven by behavior and narrative as it is by cash flow and interest rates.

The other philosophical guide we follow is collaborative decision making. We make sure that every investment idea that we put into the portfolio has multiple perspectives, and that at least two members of the team have come to the same conclusion that there is alpha embedded in the investments we make.

The reason collaboration is important for us is that public equity markets are a mix of uncertainty and ambiguity. We find that philosophically we need to have a collaborative decision-making framework in order to better interpret that mix of uncertainty and ambiguity.

Q: How would you describe your investment process?

A: Unanticipated acceleration in return on invested capital is the guiding principle of our investment process. Our team members find investment ideas using their own screens and bottom-up research process. They also meet with company management and other sources to identify investable change in the marketplace.

The ideas are vetted in the matrix structure of our team, which is divided into smaller groups we call pods. Each pod is comprised of at least three people and we have a pod for each market sector.

Once we begin working on an individual idea, we focus on three Fs: understanding the free cash flow generation of the company; forecasting what the future looks like; and factor exposure. We assess statistical attributes such as deep value or dividend yield or currency exposure. When we have developed a deep understanding through the three Fs, the portfolio manager makes the final call and configures the portfolio to match the risk profile that clients are looking for.

The last part of our process is our sell discipline. We look for situations where we do not have a gap between valuation and the current expectations of return on invested capital That sell discipline ties directly back into our initial investment process.

Q: What are unanticipated changes for you?

A: We believe that the market cannot always fully price in the full distribution of probabilities and that that opens up the opportunity for alpha to exist within a return structure. Having a structural investment framework allows an active manager to have an edge, which takes advantage of unanticipated changes. We have a very deep dedication to creative thought. The idea there is that there is alpha generation possible from an inherently creative process - whether its a unique algorithm created by a programmer and executed by a computer or an individual who is just thinking about the probability structure differently.

Thus, a creative thought process that identifies an outcome that is not contemplated fully by the market is by definition unanticipated. So thats why that phrase is such a critical part of our philosophy.

We rarely want to be exposed to the external characteristics. Our goal is to make sure we look similar enough to the Russell Mid Cap Value from a risk standpoint, and that we have a pristine allocation argument for our clients, but that we are different enough at the stock level to have a clear alpha generation opportunity. That balance is very quantitative for us.

Q: Could you illustrate your research process with a few examples?

A: One good example is Coach, Inc., the multinational luxury fashion company. Initially a handbag maker, the brand had moved into the accessory businesses and added some mens fashion -- and ultimately had fallen on hard times, with multiple years of underperformance. The company had potential as a value stock.

While the retail headwinds of the last five years had created a bad backdrop for Coach, there were some executive changes which drew our attention. They began pulling back from some retail outlets and getting back to the higher margin business, which to us signified a ROIC acceleration from profit margin. As a result, we decided to take a small position in that stock.

Our portfolio had an underexposure to retailers and that was a risk that we wanted to balance. Coach provided the retailer characteristics we were looking for to balance some of the short-term volatility that came from other retailers.

Coach is still in our portfolio. It now represents a move beyond our margin expansion thesis in that it may now be able to grow revenue through acquisition, on top of its margin expansion, which provides much more sustainable profit growth.

Q: Why did you choose Coach over other underperforming retailers like Ralph Lauren?

A: Ralph Lauren is another name we find interesting and are looking at. However they have a much more complex portfolio of products, brands, outlets, and regional distribution. Were taking some time to identify the components of the business that might lead to a successful turnaround.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc