Prospector’s approach to equity investing has long been focused on the concept of upside participation and downside risk mitigation. As conservative investors, we eschew flashy names with brilliant growth prospects in favor of high quality, value-oriented stocks that can participate in rising markets, but more importantly buffer volatility and limit downside losses when market sentiment takes a turn for the worse. Our clients don’t expect to bear the full brunt of a market selloff when it occurs, and neither do we. In what was an extremely challenging 2022 for the broad market, driven by rising inflation, sharply higher interest rates, and recession concerns, the quality and rigor of our investment process was on full display.
What differentiates our process from the approach of most equity investors is our emphasis on in-depth analysis of company balance sheets and cash flow statements. In our view, Wall Street is excessively fixated on income statements and quarterly earnings expectations. Reflecting this short-sightedness, management teams spend an inordinate amount of time massaging, polishing and offering guidance on their income statements, in spite of the fact that the income statement does little to reveal a company’s financial health and longer-term prospects.
The balance sheet and cash flow statements, on the other hand, are less vulnerable to management manipulation and offer the best opportunities to uncover signs of financial improvement or decay. Our team’s deep experience in both accounting and financial analysis gives us a significant competitive advantage in our search for mispriced opportunities, and we continue to focus on those sectors which we understand best.
When diving into a company’s balance sheet, we thoroughly analyze its integrity and value from both an accounting and a market value perspective. The left side of a balance sheet, where the assets live, is not typically a point of focus for analysts even though the actual value of things like real estate, or equity-method investments may be substantially different than what a company reports. Further, we look beyond the GAAP financial statements and closely examine regulatory filings and statutory statements when available. By analyzing regulatory statements of an insurer, for example, we are often able to estimate whether the company has been overly aggressive in setting their liability for policy reserves. In general, we like to see a high degree of conservatism in both the marking of assets and liabilities.
Moving beyond the balance sheet, we’ll typically evaluate the consistency and predictability of a company’s free cash flow. Although we do consider cyclical businesses that create strong free cash flow, we’re more likely to pay a premium for a strong, steady track record of free cash flow generation. With this approach we’re able to construct portfolios of resilient companies which are less dependent on public debt and equity markets to fund operations. This is especially important during troubled times, like we experienced in 2022, when smaller- and medium-sized companies often lose access to the capital markets.
“Price is what you pay, value is what you get.”
-Warren Buffett
For well over a decade, investors have been largely rewarded for throwing caution to the wind as low interest rates pushed growth-stock valuations to astronomical levels. In the current environment, where interest rates have moved higher, risk appetites have trended lower, and a recession is potentially unfolding, we believe investors will be required to look more closely at the underlying quality of the businesses they invest in. The market appears very conducive to a continued resurgence in value investing, and last year’s correction has indeed presented a number of attractive opportunities to invest in quality businesses whose share prices have detached from fundamentals.